4 Fiscal policy simulations (continued)

4.4  Some parameters that matter less

Several parameters affect the distribution of GDP growth over the consolidation period but not the cumulative output losses associated with it. Exchange rate variables, for example, affect the impact multiplier in the first year but work in the opposite direction in later years as the initial depreciation is offset by appreciation to achieve parity with the rest of the world.

The parameters that have this sort of influence include the degree of interest rate smoothing, the degree of habit formation, the pass-through from the exchange rate to inflation and the elasticity of output with respect to the exchange rate. None of the standard deviation variations of these parameters affects the fiscal impact multiplier by more than 0.1ppts in any single year. The sensitivity of inflation to the output gap also has a relatively small influence on cumulative output losses and the fiscal impact multiplier, although it does not fall into the same category as the other variables described in this section.

4.5  How much better or worse might it be?

The four parameters which are most important in determining the overall output losses are the sensitivity of output to interest rates, the sensitivities of interest rates to both output and inflation and the degree of non-Ricardian behaviour. If these parameters are independent, unbiased and normally distributed, the likelihood of all four of these parameters lying at one end of their respective confidence intervals simultaneously is rather small. Nonetheless, it is an interesting thought experiment to ask what the output path might be if they did. Likewise, it is informative to explore the implications for output if these parameters were to lie at the favourable end of their respective confidence intervals.

The results of this exercise suggest that the cumulative output loss associated with a one standard deviation shock to each parameter (to the side consistent with output losses) would be substantial - more than tripling the total cumulative output loss associated with the consolidation. And the fiscal impact multiplier is also larger, peaking at 0.7 in Year 3, compared with 0.4 in the baseline scenario. The average multiplier is 0.5 in this scenario compared with 0.3 in the baseline case. These results are illustrated in Figures 5a and 5b.

Figure 5 – Scenarios relative to baseline

5a) Fiscal impact multiplier vs baseline

Figure 5 - Scenarios relative to baseline

5b) Cumulative output loss/gain vs baseline

A key finding of this study is that a bad outcome is likely to be worse than a good outcome is to be better, suggesting that risks associated with the consolidation are skewed to the downside. This finding reflects the underlying distributions of the parameter estimates which are found to be skewed themselves.[25]

However, the interaction between the increased degree of non-Ricardian behaviour (which widens the output gap) and the increased persistence of the output gap arising from variations in the other model parameters means that the cumulative loss of output is greater than the sum of losses associated with varying each of the model parameters independently. This is illustrated in Figures 6a and 6b which show the contributions to the wider output gap from independent variations in model parameters and the contribution of the interaction between them.

Figure 6 – Parameter contributions

6a) Downside scenario

Figure 6 – Parameter contributions

6b) Upside scenario

4.6  Fiscal policy at the zero-lower bound

The central estimate of the average fiscal multiplier associated with a four-year fiscal consolidation is 0.3, consistent with the findings of Parkyn & Vehbi (2013). The results of the sensitivity analysis conducted here suggest that the fiscal impact multiplier is likely to be larger and the cumulative output losses substantially greater if certain model parameters differ from the central estimates. But these variations do not cause the estimated fiscal impact multiplier to reach unity - the peak impact multiplier over the consolidation period is 0.7 in the downside scenario while the average impact multiplier is 0.5.

Partly, these findings may reflect the choice of priors and so the parameters may simply not be varied by enough.[26] However, the results suggest that the functioning of the economy would have to be greatly different to the model specified here for the fiscal impact multiplier to be as large as is found by Blanchard & Leigh (2013). Given the importance of monetary policy in determining the size of the fiscal multiplier, it is useful to test whether the zero-lower bound of nominal interest rates is able to reconcile the differences. To that end, I run a simulation in which the nominal interest rate is held fixed over the period of consolidation and monetary policy is unable to stimulate aggregate demand.

In this scenario the fiscal impact multiplier is substantially higher, peaking at 0.9, and averaging 0.7 over the consolidation period. Assuming that the parameter capturing the degree of non-Ricardian behaviour lies at the unfavourable end of its distribution increases the peak multiplier to 1.2 and the average multiplier to unity - Figure 7. These estimates are fairly consistent those of Blanchard and Leigh, suggesting that much of the difference between estimates of the fiscal multiplier in New Zealand relative to other OECD countries is due to monetary policy constraints.[27]

Figure 7 - Fiscal impact multiplier at the lower bound