Journal Issue

Research Summaries: Macroeconomic Impact of Fiscal Policy

International Monetary Fund. Research Dept.
Published Date:
March 2006
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Giovanni Ganelli

Several countries use fiscal policy to stimulate economic activity. Research on this topic can therefore be useful in informing policy decisions. Despite this, the analysis of the macroeconomic impact of fiscal policy in the literature has received limited attention compared with monetary policy. Several authors, however, are shifting the focus of their research toward fiscal issues. This article surveys recent IMF research in this field.

Policymakers in industrial countries are showing a renewed interest in fiscal policy. The United States recently introduced a series of tax cuts aimed at stimulating the economy. Similarly, Japan has tried to escape slow growth through fiscal expansions. In Europe, the Stability and Growth Pact was recently reinterpreted in a way that facilitates the use of countercyclical fiscal policies.

What does economic research tell us about the likely impact of these policies? In a traditional Keynesian framework, a fiscal expansion has a positive multiplier effect on output. As stressed by Hemming, Kell, and Mahfouz (2002), however, the traditional Keynesian literature lacked microeconomic foundations and was largely based on adaptive expectations. Introducing state-of-the-art modeling assumptions—such as intertemporal optimization and rational expectations—implies a Ricardian equivalence proposition. Since rational agents anticipate that a tax cut today will be paid off in the future, they adjust their behavior to neutralize its impact. One interesting question therefore is under which circumstances this policy retains its effectiveness when agents are perfectly rational.

Bayoumi and Sgherri (2005) develop an intertemporal model in which the consumers’ rate of discount of the future is higher than the real interest rate. Consumers therefore value current tax cuts more than future tax increases and Ricardian equivalence is broken. The model implies increases in private consumption in the range of 0.15–0.4 percent of the tax cuts, depending on the assumed degree of excess discount.

“Fiscal contractions can have expansionary effects, since they can contribute to a consumption and investment boom owing to altered expectations regarding future taxation.”

Ganelli (2005a) studies similar issues by incorporating an overlapping-generations structure (Blanchard, 1985) in an intertemporal open economy. Since the consumers who benefit from a tax cut today will not necessarily be alive to repay the resulting debt tomorrow, a debt-financed tax reduction stimulates domestic consumption. This, in turn, increases domestic money demand compared with foreign money demand, causing the exchange rate to appreciate. The expenditure-switching effect associated with this appreciation implies a positive international spillover. Foreign output increases more than domestic output. The long-run net financial position of the domestic country therefore worsens, consistent with the empirical findings of Lane and Milesi-Ferretti (2001). If the increase in debt is used to finance an increase in government spending (rather than a tax cut), these results still hold as long as the probability of dying in each period—a measure of the deviation from Ricardian equivalence—is large enough.

The IMF’s Global Fiscal Model (GFM), developed by Botman, Laxton, Muir, and Romanov (2005), extends Ganelli (2005a) by introducing more general preferences, nontraded goods, and the assumption that a fraction of consumers face credit constraints. This assumption provides an additional channel through which Ricardian equivalence is broken. Simulations based on GFM show that the increase in domestic consumption compared with foreign consumption can be mitigated by low levels of the intertemporal elasticity of substitution or by a large elasticity of substitution between domestic and foreign goods. The introduction of credit-constrained consumers in GFM has a limited impact in determining the quantitative effects of public debt, consistent with findings of Bayoumi and Sgherri (2005) and Coenen and Straub (2005).

GFM has also been used to address specific policy issues. Kumhof, Laxton, and Muir (2005) calibrate it to the U.S. economy, showing that a permanent improvement of one percentage point in the fiscal balance would generate an average current account improvement of about one-half of 1 percentage point of GDP over 10 years. Bayoumi, Botman, and Kumar (2005) use GFM to simulate the impact of social security reform in the United States, finding that government debt and the fiscal deficit would significantly increase as payroll contributions were diverted to personal retirement accounts (PRAs). The macroeconomic impact would be limited because private saving through PRAs would offset government dissaving. If higher taxes were used to prevent the PRA-related increase in government debt, output would be modestly reduced in the short run, while lower government debt would reduce real interest rates and boost investment in the long run.

In all the papers referred to in the preceding discussion, Ricardian equivalence does not hold. When Ricardian equivalence holds, public debt has no real effects but balanced-budget fiscal expansions still have macroeconomic impacts. These policies typically have a negative effect on domestic consumption compared with foreign consumption. The reason is that domestic residents have to foot the tax bill, while the increase in government spending falls partly on foreign goods. Ganelli (2003) shows that the latter does not necessarily imply a reduction in domestic welfare if government spending is assumed to be useful for private consumers. In addition, an increase in the degree of home bias of government spending can, by reducing the extent to which domestic taxpayers finance the foreign expansion, mitigate the fall in domestic consumption (Ganelli, 2005b). Measures aimed at improving the efficiency of public spending have a similar effect (Ganelli, 2004). A topic which has received little attention in the literature is the differentiation between spending for public consumption and public employment. Ganelli (2005c) investigates this issue in a theoretical model, showing that the composition of spending matters for the macroeoconomic impact of fiscal policy.

The papers reviewed so far show that different theoretical models imply different macroeconomic effects of fiscal policy. The empirical evidence is also mixed. Fiscal contractions can have expansionary effects, since they can contribute to a consumption and investment boom owing to altered expectations regarding future taxation (Giavazzi and Pagano, 1990). A study of large fiscal adjustments carried out by the IMF’s Fiscal Affairs Department on a wide sample of countries (IMF, 2004) concludes that positive macroeconomic developments generally accompany large fiscal adjustments. Among large adjustments, the best macroeconomic performance is associated with gradual and sustained consolidations. The possibility of expansionary fiscal contractions is confirmed by Gupta and others (2002) for a panel of low-income countries; by Gupta, Segura-Ubiergo, and Simone (2005) for a panel of transition countries; and by Kandil (2004) for the United States. Devereux and Choi (2005), however, estimate threshold VAR models using quarterly U.S. data and find that an expansionary fiscal policy is conducive to growth when the economy faces low interest rates. Hemming, Mahfouz, and Schimmelpfennig (2002) empirically analyze the fiscal response to recession episodes in advanced economies, finding that fiscal expansions stimulate economic activity during recessions but the multipliers are unlikely to exceed unity.

The fact that a consensus view on the macroeconomic impact of fiscal policy has not yet emerged confirms that this is an exciting area for further research.


    BayoumiTamimDennisBotman and ManmohanS. Kumar2005“Macroeconomic Effects of Social Security and Tax Reform in the United States,”IMF Working Paper 05/208.

    BayoumiTamim and SilviaSgherri2005“Mr. Ricardo’s Great Adventure: Estimating Fiscal Multipliers in a Truly Intertemporal Model” (unpublished; Washington: IMF).

    BlanchardOlivier J.1985“Debt, Deficits and Finite Horizons,”Journal of Political EconomyVol. 93 pp. 22347.

    BotmanDennisDouglasLaxtonDirkMuir and AndreiRomanov2005“A New Open Economy Macro Model for Fiscal Policy Evaluation” (unpublished; Washington: IMF).

    CoenenGunther and RolandStraub2005“Does Government Spending Crowd In Private Consumption? Theory and Empirical Evidence for the Euro Area,”IMF Working Paper 05/159.

    DevereuxMichael B. and Woon GyuChoi2005“Asymmetric Effects of Government Spending: Does the Level of the Real Interest Rates Matter?”IMF Working Paper 05/04.

    GanelliGiovanni2003“Useful Government Spending, Direct Crowding-Out and Fiscal Policy Interdependence,”Journal of International Money and FinanceVol. 22 pp. 87103.

    GanelliGiovanni2004“Public Spending Management and Macroeconomic Interdependence,”IMF Working Paper 04/102.

    GanelliGiovanni2005a“The New Open Economy Macroeconomics of Government Debt,”Journal of International EconomicsVol. 65 pp. 16784.

    GanelliGiovanni2005b“Home Bias in Government Spending and Quasi Neutrality of Fiscal Shocks,”Macroeconomic DynamicsVol. 9 pp. 28894.

    GanelliGiovanni2005c“The International Effects of Government Spending Composition,”IMF Working Paper 05/4.

    GiavazziFrancesco and MarcoPagano1990“Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries” NBER Macroeconomics AnnualVol. 4 (Cambridge, Massachusetts: MIT Press).

    GuptaSanjeevBenedictClementsEmanueleBaldacci and CarlosMulas-Granados2002“Expenditure Composition, Fiscal Adjustment, and Growth in Low-Income Countries,”IMF Working Paper 02/77; also published in Journal of International Money and FinanceVol. 24 (2005) pp. 44163.

    GuptaSanjeevAlexSegura-Ubiergo and AlejandroSimone2005“Fiscal Adjustment and Growth in Transition Countries: New Evidence from Panel Data and Country Experiences” (unpublished; Washington: IMF).

    HemmingRichardMichaelKell and SelmaMahfouz2002“The Effectiveness of Fiscal Policy in Stimulating Economic Activity—A Review of the Literature,”IMF Working Paper 02/208.

    HemmingRichardSelmaMahfouz and AxelSchimmelpfennig2002“Fiscal Policy and Economic Activity During Recessions in Advanced Economies,”IMF Working Paper 02/87.

    International Monetary Fund (IMF)2004“Experience with Large Fiscal Adjustments” (unpublished; Washington: International Monetary Fund, Fiscal Affairs Department).

    KandilMagda2004“Variation in the Effects of Government Spending Shocks with Methods of Financing: Evidence from the U.S.” (unpublished; Washington: International Monetary Fund); also forthcoming in the International Review of Economics and Finance.

    KumhofMichaelDouglasLaxton and DirkMuir2005“Consequences of Fiscal Consolidation for the U.S. Current Account: United States—Selected Issues,”IMF Staff Country Report No. 05/258 (Washington: International Monetary Fund).

    LanePhilip and Gian MariaMilesi-Ferretti2001“Long-Term Capital Movements,”IMF Working Paper 01/107; also published in NBER Macroeconomics AnnualVol. 16 (2002) (Cambridge, Massachusetts: MIT Press).

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