Expectations and Fiscal Policy: How Foresight Affects Policy Transmission

Abstract

This thesis studies how expectations a ect scal policy transmission. It revisits the empirical evidence on the domestic and cross-border e ects of fiscal policy at the light of scal foresight. Fiscal measures are the result of a complex decision process, entailing long lags be- tween the moment when the decision is taken and when it is e ectively implemented. It follows that scal policy can be easily anticipated, with agents modifying their actions when they receive signals about changes in policy, well before the actual implementation. This anticipation poses non-trivial challenges for the empirical analysis. It implies that economic variables may move well before the policy shocks estimated in macroeconomic models take place. Overlooking the e ects of anticipation can be a major problem in VAR models. The parsimony required to conserve degrees of freedom makes the information carried by the few endogenous variables contained in the model much smaller than the information possessed by private agents. This leads to a problem of non-fundamentalness that might bias estimation results. The predictability of scal actions is likely to in uence their cross-border e ects as well. National scal policies can a ect other countries through a variety of potential channels. First, an increase in public spending could fall on foreign products, stimulating directly the foreign economy. Second, an expansionary policy could stimulate domestic economic activity, leading to more imports from other countries and thus helping to stimulate foreign activity as well. Third, if the scal expansion results in higher public debt, it could push long-term interest rates up in nancial partners, crowding out private investment. Government's nances could even become unsustainable with the risk of a systemic crisis. The innovative contribution of this thesis is to study scal spillovers and scal an- ticipation together. The aim is to estimate how national scal measures a ect foreign economies through an approach that allows to solve the problem of non-fundamentalness in VAR analysis, while at the same time assessing the role of expectations for the inter- national transmission of scal policy. The questions of interest that this analysis aims at answering are the following: are policy shocks estimated in standard scal VAR models really unanticipated? How does anticipation in uence domestic and cross-border e ects? What are the implications for real economic activity of a change in forecasts about policy actions? Should governments consider the implications of their claims and actions for the formation of expectations? Should national scal policies be coordinated at a supra- national level? These questions have important policy implications that encouraged me to delve into these issues further and study them in depth. The thesis comprises three chapters. The rst chapter provides a survey of the VAR models used in the empirical literature. The second and third chapters assess from a 1 di erent perspective and with a di erent focus how the anticipation of future policy regimes changes the transmission of scal shocks. The rst chapter reviews how the econometric model adopted in this thesis -the vector autoregression (VAR) - has been used in the empirical literature on scal policy. First, it illustrates the basic characteristics of the VAR approach, describing the reasons behind its widespread use in applied macroeconomic research. Second, it analyzes the challenges that the VAR approach poses. Standard VAR models need to be identi ed in order to perform structural analysis, giving economic meaning to the shocks estimated in these systems. This chapter reviews the di erent approaches proposed in the literature to solve the problem, classifying them in four main categories. Standard VAR models are also low- dimensional models. The parsimony is imposed in order to conserve degrees of freedom and implies that VAR models can carry only a limited amount of information. The misalignment of the information space between private agents and econometricians may lead to a problem of non-fundamentalness, biasing the estimation of policy innovations. Discussing the solutions to this problem, I describe some innovative speci cations of the basic approach which address this issue by taking advantage of the improvements in computing power and data availability (GVAR, FAVAR, Panel VAR). An ulterior limitation of standard VAR models is linearity. In this regard, this chapter outlines a further enhancement which allows for time-varying relationships among endogenous variable (TVC-VAR). Finally, the rst chapter focuses on reviewing how VAR models have been used to study the international transmission of scal shocks, addressing the issue of cross-border e ects. The second chapter estimates the impact of expectations on scal spillovers. More precisely, the analysis studies how the anticipation of the future scal stance a ects the international transmission of scal measures in the US. To address this challenge use a set of two-country Bayesian VAR models. In each model, the US is the domes- tic economy, considering its leading role in the global economy. As foreign countries, I include Canada, France, Germany and UK because they represent the lion share of US foreign trade. The innovative feature of this contribution is to apply an identi - cation strategy which di erentiates an unanticipated or surprise shock from a foresight or news shock. The former represents a discretionary increase in government spending that was not foreseen by agents. The latter represents news received by agents which a ect their expectations about prospective policy actions. The Philadelphia FED Survey of Professional Forecasters provides the data used to construct the indicators of scal forecast. This approach has a twofold advantage: it allows to address the problem of non-fundamentalness, as well as to assess the international repercussions of both surprise and foresight shocks. Results show the importance of expectations for the international transmission of US scal policies. A surprise scal stimulus has negligible cross-border e ects when it is associated with expectations of spending reversals. Foresight shocks, on the contrary, are associated with expectations of increasing government spending and yield positive spillovers, despite no expansionary action is taken. The sign and magnitude of these external e ects are country sensitive, suggesting an active role of country-speci c factors in a ecting the international transmission of US scal policies. These ndings provide novel evidence in support of the hypothesis that foresight alters scal policy e ects on a national and international level. The third chapter provides further evidence in support of the hypothesis that scal policy is largely anticipated and its e ects depend on expectations. The analysis draws on two-country VAR models between major European economies and applies the same identi cation approach adopted in the second chapter, using this time the o cial fore- casts of the European Commission to construct the indicators of scal forecast. Data refer to Italy, France and Germany over the period 1971-2011. This third contribu- tion rst documents the forecasting accuracy of the European Commission forecasts and shows that they help address the problem of non-fundamentalness in scal VAR models. Then, it identi es surprise and foresight shocks through a recursive ordering in which the realized policy does not react within the year to innovations in any other variable in the system. The expected policy, on the contrary, is allowed to react to innovations in the realized policy, re ecting the revision of expectations upon arrival of news. The ndings show that an unanticipated scal stimulus leads to expectations of strong de cit reversals over the subsequent two to three years. This in turn depresses domestic and foreign activity over the same horizon. Foresight shocks, on the contrary, have positive e ects on domestic activity. Di erences in the responses to surprise and foresight shocks re ect the role of expectations. The evidence is consistent with a regime where de cit reversals are mainly based on taxation alone and suggests that the incentive to reform scal regimes in an uncoordinated way may be small, while incentives for opportunistic behavior may be strong. Final Remarks The thesis has examined how the anticipation of future policy regimes in uence the e ects of discretionary scal actions on a national and international level. The analysis draws on the VAR approach with an identi cation scheme that allows to estimate the e ects of truly unanticipated scal measures as well as changes in expectations about future policies. The results obtained provide support to the hypothesis that foresight a ects signi cantly the response of domestic and foreign economies to scal policy. More in details: Chapter 2 tells us that a scal stimulus in the US produces a temporary boost in domestic output and has no e ects on foreign economies as long as it is associated with expectations of spending reversals. Conversely, the anticipation of an expansionary policy has positive e ects on both domestic and foreign output, despite no scal measure is taken. Chapter 3 tells us that expectations about future policy actions in uence the trans- mission of scal policy in Europe. Expansionary policies associated with previsions of strong expenditure retrenchments over the subsequent two to three years depress domes- tic and foreign activity over the same period. Forecasts of expansionary de cit- nanced measures, on the contrary, have positive e ects on domestic output. The evidence provided in this thesis has non-negligible policy implications. First, it shows that the e ects of scal policy depend strongly on how agents foresee future policy actions. Second, it highlights that scal policy is e ective as long as it succeeds in steering expectations. This revives the debate on the credibility of policy institutions as a necessary prerequisite for optimal policy. Third, it con rms the existence of scal cross-border e ects, providing support to the theory that a coordinated approach to scal policy on an international base could be bene cial. In this regard, it also suggests that the incentive to reform scal regimes in an uncoordinated way may be small. On the one side, the incentives for opportunistic behavior may be strong. The thesis can be extended further in a number of directions. For example, the proposed VAR analysis can be applied to a panel dataset, exploiting the cross-country dimension much further through the analysis of dynamic and static interdependencies. Another direction for extension of this research concerns the possibility to allow for regime-dependent responses. Strong recessions or persistent periods of steady economic growth can in uence the way agents formulate forecasts, changing the e ects that these forecasts have on scal policy transmission.