5 Implications for policy and research
The key findings of the research presented here are that uncertainty surrounding the effects of fiscal consolidations on output can be attributed to several model parameters and that a bad outcome is likely to be worse than a good outcome is to be better. Overall, the evidence suggests that policy makers should be sensitive to the prevailing economic environment when determining the fiscal stance because cumulative output losses can vary substantially in some situations - particularly when monetary policy is constrained by the lower bound of nominal interest rates.
The responsiveness of aggregate demand to changes in interest rates is a key determinant of the output losses associated with any fiscal consolidation. This is thought to be related to a structural parameter - the elasticity of intertemporal substitution - which, in turn, is often considered to be stable and not to fluctuate over the cycle. This is of particular interest at the current juncture since little is known about how the structural position of household and corporate balance sheets might affect those agents' willingness to bring consumption forward in response to lower interest rates. Further work into the validity of this assumption would improve our understanding of the effects of fiscal consolidations on the economy.
The degree of monetary activism - how much a central bank might be expected to move interest rates in response to an announced fiscal consolidation - is also an important determinant of the effect of consolidations on output. And, in extremis, when monetary policy is constrained by the zero lower bound of interest rates, the effects of fiscal tightening are likely to be much larger. The implication is that central banks and fiscal authorities should coordinate their activities closely if the worst outcomes are to be avoided.
The degree of non-Ricardian behaviour, which (due to the reduced-form nature of the model) also includes the effect of trade leakages, is of particular importance. When setting policy governments should consider whether the particular mix of measures is likely to affect households likely to exhibit more or less Ricardian behaviour. A government should also consider whether the package it designs is likely to be more or less prone to leakage, reflecting the import intensity of certain areas of expenditure, for example. This reduces the uncertainty over this parameter to the extent that the central estimate can be thought of as being based on the average effect of a number of packages which differ in their precise make-up.
A broader question is how this information should shape a government's policy choices. In the parallel literature on optimal monetary policy, uncertainty over model parameters implies an inertial response of interest rates to shocks. The issue for fiscal authorities is rather more complicated since the benefits of reducing structural budget deficits need to be balanced against the output losses associated with fiscal consolidations - I leave this area unexplored but it stands to reason that the asymmetric output losses arising from parameter uncertainty might incentivise a degree of gradualism in policy setting.
