Debt and the Effects of Fiscal Policy

29 Pages Posted: 14 May 2008

See all articles by Carlo A. Favero

Carlo A. Favero

Bocconi University - Department of Economics; Bocconi University - Department of Finance; Centre for Economic Policy Research (CEPR)

Francesco Giavazzi

National Bureau of Economic Research (NBER); University of Bocconi - Innocenzo Gasparini Institute for Economic Research (IGIER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: February 2007

Abstract

A shift in taxes or in government spending (a "fiscal shock") at some point in time puts a constraint on the path of taxes and spending in the future, since the government intertemporal budget constraint will eventually have to be met. This simple fact is surprisingly overlooked in analyses of the effects of fiscal policy based on Vector AutoRegressive models. We study the effects of fiscal shocks keeping track of the debt dynamics that arises following a fiscal shock, and allowing for the possibility that taxes, spending and interest rates might respond to the level of the debt, as it evolves over time. We show that omitting a debt feedback can result in incorrect estimates of the dynamic effects of fiscal shocks. In particular, the absence of an effect of fiscal shocks on long-term interest rates - a frequent finding in studies that omit a debt feedback - can be explained by their mis-specification. Using data for the U.S. economy and two alternative identification assumptions we reconsider the effects of fiscal policy shocks correcting for these shortcomings.

Keywords: Fiscal policy, government budget constraint, public debt, VAR models

JEL Classification: E62, H60

Suggested Citation

Favero, Carlo A. and Giavazzi, Francesco and Giavazzi, Francesco, Debt and the Effects of Fiscal Policy (February 2007). CEPR Discussion Paper No. DP6092, Available at SSRN: https://ssrn.com/abstract=1132229

Carlo A. Favero (Contact Author)

Bocconi University - Department of Economics ( email )

Via Gobbi 5
Milan, 20136
Italy

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

HOME PAGE: http://www.igier.unibocconi.it\favero

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Francesco Giavazzi

University of Bocconi - Innocenzo Gasparini Institute for Economic Research (IGIER) ( email )

Via Roentgen 1
Milan, 20136
Italy
+39 02 5836 3304 (Phone)
+39 02 5836 3302 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
7
Abstract Views
797
PlumX Metrics