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Short-Run Effects of Fiscal Policy with Forward-Looking Financial Markets

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  • Elmendorf, Douglas W.
  • Reifschneider, David L.
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    Abstract

    We explore the short-run effects of fiscal policy using simulations of an empirical, rational-expectations, open-economy macromodel developed at the Federal Reserve Board. Based on this model, we find that tax cuts and spending increases generally stimulate economic activity in the short run, contrary to the extreme view that forward-looking financial markets more than offset the direct expansionary impulse of those actions. However, the magnitude of the stimulus is greatly attenuated by the financial-market feedback. For example, a sustained cut in personal income taxes raises output by less than the amount of the tax cut itself, and it likely reduces output (relative to baseline) in the first several years if phased in gradually over time. Our results also show that the estimated stimulus imparted by fiscal policy is sensitive to reasonable variation in the model’s parameters.

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    Bibliographic Info

    Article provided by National Tax Association in its journal National Tax Journal.

    Volume (Year): 55 (2002)
    Issue (Month): 3 (September)
    Pages: 357-86

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    Handle: RePEc:ntj:journl:v:55:y:2002:i:3:p:357-86

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    1. Alberto Alesina & Roberto Perotti, 1997. "Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects," IMF Staff Papers, Palgrave Macmillan, Palgrave Macmillan, vol. 44(2), pages 210-248, June.
    2. Christopher D. Carroll, 2001. "A Theory of the Consumption Function, With and Without Liquidity Constraints (Expanded Version)," NBER Working Papers 8387, National Bureau of Economic Research, Inc.
    3. Matthew D. Shapiro & Joel Slemrod, 1993. "Consumer Response to the Timing of Income: Evidence from a Change in Tax Withholding," NBER Working Papers 4344, National Bureau of Economic Research, Inc.
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    Cited by:
    1. Martin Feldstein, 2002. "The Role for Discretionary Fiscal Policy in a Low Interest Rate Environment," NBER Working Papers 9203, National Bureau of Economic Research, Inc.
    2. David L. Reifschneider & John M. Roberts, 2005. "Expectations formation and the effectiveness of strategies for limiting the consequences of the zero bound on interest rates," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2005-70, Board of Governors of the Federal Reserve System (U.S.).
    3. William Gale & Peter Orszag, 2005. "Economic Effects of Making the 2001 and 2003 Tax Cuts Permanent," International Tax and Public Finance, Springer, Springer, vol. 12(2), pages 193-232, March.
    4. Edge, Rochelle M. & Rudd, Jeremy B., 2011. "General-equilibrium effects of investment tax incentives," Journal of Monetary Economics, Elsevier, Elsevier, vol. 58(6), pages 564-577.
    5. Afonso, António & Martins, Manuel M.F., 2012. "Level, slope, curvature of the sovereign yield curve, and fiscal behaviour," Journal of Banking & Finance, Elsevier, Elsevier, vol. 36(6), pages 1789-1807.
    6. Blanchard, Olivier J & Cottarelli, Carlo & Spilimbergo, Antonio & Symansky, Steven, 2009. "Fiscal Policy for the Crisis," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7130, C.E.P.R. Discussion Papers.
    7. Benjamin M. Friedman, 2005. "Deficits and Debt in the Short and Long Run," NBER Working Papers 11630, National Bureau of Economic Research, Inc.
    8. Diego E. Vacaflores, 2013. "Monetary Transfers in the U.S.: How Efficient Are Tax Rebates?," Economies, MDPI, Open Access Journal, MDPI, Open Access Journal, vol. 1(3), pages 26-48, November.

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