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

  • Elmendorf, Douglas W.
  • Reifschneider, David L.
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    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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    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, vol. 44(2), pages 210-248, June.
    2. Shapiro, Matthew D & Slemrod, Joel, 1995. "Consumer Response to the Timing of Income: Evidence from a Change in Tax Withholding," American Economic Review, American Economic Association, vol. 85(1), pages 274-83, March.
    3. Christopher D. Carroll, 2001. "A Theory of the Consumption Function, with and without Liquidity Constraints," Journal of Economic Perspectives, American Economic Association, vol. 15(3), pages 23-45, Summer.
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