4 Fiscal policy simulations
In this section, I first set out a fiscal policy simulation using the estimated model parameters, which serves as the baseline case against which other simulations are compared. I then vary the model parameters one at a time, to show the sensitivity of the fiscal impact multiplier and associated cumulative output losses to those parameters. The variations are proportionate to the confidence intervals obtained during the Bayesian estimation procedure, which serve as proxies for parameter uncertainty.
4.1 A baseline fiscal consolidation
The baseline fiscal consolidation scenario presented here is based on a four-year consolidation program equal to a one per cent of GDP tightening in each year, starting one quarter after it is announced. The full consolidation is, therefore, expected by the central bank, foreign exchange market participants and households. Figures 1a and 1b illustrate the dynamics of the four key model variables in response to a scheduled fiscal consolidation.
- Figure 1 – Baseline simulation dynamics
- 1a) Interest and exchange rates
- Figure 1 – Baseline simulation dynamics
- 1b) Output and inflation
The charts show that the exchange rate depreciates at the point of announcement, while interest rates fall with a degree of inertia. The level of prices rises initially, reflecting the increase in import costs associated with the currency depreciation. The exchange rate depreciation provides support to output over the first year; thereafter the output gap opens up and exerts downward pressure on the annual rate of inflation. The output gap continues to widen over the period of fiscal consolidation, implying a negative GDP growth effect and a positive fiscal impact multiplier.
Figure 2a shows that the fiscal impact multiplier is small in the first year as much of the effect of the consolidation is offset by the output effects of currency depreciation. Thereafter, the multiplier rises to around 0.4 before shrinking to around 0.3 toward the end of the consolidation period. The average fiscal impact multiplier over the consolidation period is also 0.3.
- Figure 2 – Baseline fiscal effects
- 2a) Fiscal impact multiplier
- Figure 2 – Baseline fiscal effects
- 2b) Cumulative output loss
The opening of the output gap is associated with a cumulative loss of income of around 6 per cent of annual GDP - illustrated in Figure 2b. This output will never be recovered since there is no offsetting positive output gap following the consolidation - i.e. the level of output returns to its steady-state growth path and remains there.
The risks associated with speed of consolidation are not quantified here. Varying the pace of the fiscal consolidation by, for example, compressing the duration over which it takes place to two years does not yield a larger estimated cumulative output loss or a larger fiscal multiplier. The implication is that fiscal policy can be set without any regard to speed of consolidation and, in effect, makes achieving fiscal balance today just as costly as achieving it over four years - this is a limitation that arises from the linearity of the model.
Adjusting the baseline scenario so that the consolidation starts in a year's time (rather than the next quarter) affects the profile of GDP growth over time. This is because the exchange rate adjusts at the point of announcement, not when the consolidation begins, which means the associated benefits to growth are felt before consolidation begins. But this simply brings demand forward from later years and, overall, the cumulative gains associated with preannouncement are small - equal to around 0.1 per cent of annual GDP over the period in which the consolidation takes place.
4.2 Measuring parameter uncertainty
I have used the confidence intervals from the Bayesian estimation for the relevant parameters as proxies for parameter uncertainty. Table 2 ranks the model parameters by the cumulative output losses (relative to baseline) associated with a one standard deviation variation from their respective estimated values.[23] The mean estimates for each of the model parameters do not always lie at the centre of their estimated distributions - some of them are skewed. This means that not all parameters are varied symmetrically proportionate to the mean estimates - this introduces a skew to some of the simulated cumulative output loss scenarios.
| Equation | Description | Cumulative output loss -1 s.d. |
Cumulative output loss +1sd |
Cumulative output loss -1sd vs baseline |
Cumulative output loss +1sd vs baseline |
|---|---|---|---|---|---|
| TR | Interest rate sensitivity to output gap | 9.2 | 4.4 | 3.0 | -1.7 |
| IS | Interest rate elasticity of demand | 8.7 | 4.6 | 2.5 | -1.6 |
| TR | Interest rate sensitivity to inflation | 8.2 | 4.8 | 2.1 | -1.4 |
| IS | Degree of non-Ricardian behaviour | 4.3 | 8.0 | -1.9 | 1.8 |
| PC | Inflation sensitivity to output gap | 6.7 | 5.6 | 0.6 | -0.6 |
| PC | Inflation persitence | 6.2 | 5.9 | 0.0 | -0.2 |
| RUIP | Error correction coefficient | 6.0 | 6.1 | -0.2 | -0.1 |
| TR | Interest rate smoothing parameter | 6.0 | 6.2 | -0.2 | 0.0 |
| IS | Degree of habit formation | 6.1 | 6.0 | 0.0 | -0.2 |
| IS | Exchange rate elasticity of demand | 6.1 | 6.0 | -0.1 | -0.1 |
| PC | Exchange rate sensitivity of inflation | 6.1 | 6.0 | -0.1 | -0.1 |
4.3 Some parameters that matter
The degree of monetary activism is captured by the responsiveness of interest rates to both the output gap and deviations of inflation from target. The persistence of the output gap is affected by variations in both of these parameters and the risks posed by both the fiscal impact multiplier and cumulative losses are skewed to the downside.
The interest rate elasticity of demand represents the willingness of households to swap consumption today for consumption tomorrow. It is important because it determines how effective a given interest rate change will be in stimulating aggregate demand and variations in this parameters alter the persistence of the output gap. The results show that the risks posed to both the cumulative output losses and associated fiscal impact multipliers are skewed to the downside when this parameter is varied.
The degree of non-Ricardian behaviour[24] introduces considerable uncertainty over the likely effect of fiscal consolidation on the economy. This is not surprising since it is the scalar for the size of the initial shock. The results are consistent with a broadly symmetric loss/gain in cumulative output and varying this parameter has a roughly equal effect on the impact multiplier when varied in both directions.
- Figure 3 – Variations in output responses
- 3a) Output gap simulations
- Figure 3 – Variations in output responses
- 3b) Output gaps relative to baseline
- Figure 4 – Variations in fiscal effects
- 4a) Fiscal impact multiplier vs baseline
- Figure 4 – Variations in fiscal effects
- 4b) Cumulative output loss vs baseline
The output gap paths associated with independently varying each of the four parameters above by one standard deviation of the parameter estimate are presented in Figure 3a while Figure 3b shows these in terms of deviations from the baseline scenario. The simulation shows that a higher degree of non-Ricardian behaviour would reduce output sooner and more sharply than would a lower interest rate elasticity of demand or interest rate sensitivity to the output gap/inflation. This is reflected in estimates of the fiscal impact multiplier illustrated in Figures 4a and 4b.
