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Debt and the Effects of Fiscal Policy

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  • Giavazzi, Francesco
  • Favero, Carlo A.

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.

Suggested Citation

  • Giavazzi, Francesco & Favero, Carlo A., 2007. "Debt and the Effects of Fiscal Policy," CEPR Discussion Papers 6092, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:6092
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    References listed on IDEAS

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    More about this item

    Keywords

    Fiscal policy; Government budget constraint; Public debt; Var models;
    All these keywords.

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • H60 - Public Economics - - National Budget, Deficit, and Debt - - - General

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