Executive summary
The global financial crisis, which began in 2008, led to a significant deterioration in the fiscal positions of many governments, with a number of advanced economies running structural budget deficits in the years that followed - those expected to remain once the economic cycle has run its course and output has returned to its sustainable level.
Many governments have responded to the deterioration of their fiscal positions by planning large consolidations - usually a mix of spending cuts and tax increases, with most balanced towards the former. A natural question to ask is to what extent might these plans reduce aggregate demand in the economy and, in doing so, slow its cyclical recovery? For the purposes of policy making, it is also helpful to make an assessment of the circumstances under which the effects of fiscal tightening might be more or less severe than expected.
To make this assessment I run fiscal policy simulations using a small estimated model of the New Zealand economy. By varying the parameters of the model I illustrate the sensitivity of estimated output losses to assumptions over the way the economy functions. It is found that uncertainty over the effects of fiscal consolidations can be attributed to a number of model parameters but that some are more important than others.
Of key importance are the degree of monetary activism (how much interest rates can be expected to change in response to a fiscal policy announcement), the responsiveness of demand to changes in the stance of monetary policy and the proportion of those in society who do not change their consumption plans in response to changes in fiscal policy.
I find that the average fiscal multiplier associated with a four-year consolidation in New Zealand is around 0.3, consistent with the findings of Parkyn and Vehbi (2012). Constructing a scenario in which the model parameters mentioned above lie at the unfavourable ends of their distributions causes the average fiscal impact multiplier to rise to 0.5. Furthermore I find that a bad outcome is likely to be worse than a good outcome is to be better – output risks are skewed to the downside. Both estimates lie significantly below those estimated for other advanced economies by Blanchard and Leigh (2013), whose central estimate of the fiscal multiplier is close to unity.
To test whether the differences can be reconciled by monetary policy being constrained by the lower bound of nominal interest rates, I run a scenario in which they are held fixed. I find the estimated fiscal multiplier rises significantly, consistent with the empirical evidence for a number of OECD economies presented by Blanchard and Leigh.
The policy implications of this work are that fiscal policy makers should be sensitive to the prevailing economic environment when determining the fiscal stance, particularly when interest rates are close to the zero-lower bound, and work closely with central banks if the worst outcomes are to be avoided.
