5 Fiscal policy and the business cycle
In the previous section, the dynamic responses to government spending and net tax shocks were analysed using impulse response functions. In this section, we calculate the forecast error variance decompositions (FEVD) as another way to assess how shocks to economic variables transmit through a system. We only report the decomposition of output but full results are also available on request. Next, we use historical decompositions of the fiscal VAR to assess the contribution of fiscal policy shocks to the New Zealand business cycle over 1985:1 to 2010:2. We use this to draw some conclusions about the cyclical stance of fiscal policy over time.
5.1 Forecast error variance decompositions
FEVDs for each variable measure the contribution of each type of shock to the forecast error variance of that variable. Thus, they provide information about the relative importance of each shock in affecting the endogenous variables in the VAR.
Table 5 shows the results of the variance decompositions of output. In line with the majority of fiscal VAR studies, the shocks to output itself (ie, residual) explain almost all of its forecast error variance at short horizons. This is in line with the findings of Dungey and Fry (2009). Fiscal shocks in total explainapproximately 6 and 13 percent of the forecast error variation in output within 12 and 20 quarters respectively. Net tax shocks are found to have relatively more impact on the variations in output then spending shocks.
Thus, consistent with Claus et al. (2006), we find that the impact of fiscal policy on the GDP cycle has been relatively small.
| Horizon, quarters | Spending shock | Revenue shock | Output shock |
|---|---|---|---|
| 1 | 1.50 | 2.58 | 95.83 |
| 4 | 2.49 | 3.68 | 89.61 |
| 12 | 1.32 | 5.25 | 84.03 |
| 20 | 1.62 | 11.58 | 74.95 |
