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Macroeconomic effects of fiscal adjustment: A tale of two approaches

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  • Yang, Weonho
  • Fidrmuc, Jan
  • Ghosh, Sugata

Abstract

We investigate the short-term effects of fiscal adjustment on economic activity in 20 OECD countries from 1970 to 2009. We compare two approaches: the traditional approach based on changes in cyclically adjusted primary balance (CAPB) and the narrative approach based on historical records. Proponents of the latter argue that it captures discretionary fiscal adjustment more accurately than the traditional approach. We propose a new definition of CAPB that takes account of fluctuations in asset prices and reflects idiosyncratic features of fiscal policy in individual countries. Using this new definition, we find that fiscal adjustments always have contractionary effects on economic activity in the short term; we find no evidence of expansionary (non-Keynesian) fiscal adjustments. Spending-based fiscal adjustments lead to smaller output losses than tax-based fiscal adjustment. These results are in line with the literature using the narrative approach, suggesting that the CAPB, when correctly specified, can be used as a measure of fiscal adjustments.

Suggested Citation

  • Yang, Weonho & Fidrmuc, Jan & Ghosh, Sugata, 2015. "Macroeconomic effects of fiscal adjustment: A tale of two approaches," Journal of International Money and Finance, Elsevier, vol. 57(C), pages 31-60.
  • Handle: RePEc:eee:jimfin:v:57:y:2015:i:c:p:31-60
    DOI: 10.1016/j.jimonfin.2015.05.003
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    More about this item

    Keywords

    Fiscal policy; Fiscal adjustment; Narrative approach; Cyclically adjusted primary balance;
    All these keywords.

    JEL classification:

    • E13 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Neoclassical
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy

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