Measure to Measure: The Effect of Fiscal Policy on Growth and Stability

IMF Blog, April 15, 2015

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Canonical URL: Measure to Measure: The Effect of Fiscal Policy on Growth and Stability

Author: Vitor Gaspar
Date: April 15, 2015
Core questions addressed:
- Does fiscal policy respond systematically to economic activity?
- Can fiscal policy promote macroeconomic stability?
- Does greater stability support stronger growth?
Summary answer given: "The answer is yes on all counts."

Definition:
- FISCO measures how much a country’s overall budget balance changes in response to a change in economic slack (as measured by the output gap).
- Example interpretation: If FISCO is equal to 1 it means that when output falls below potential by 1% of GDP, the overall balance worsens by the same percentage of GDP.
Empirical values:
- The average FISCO among advanced economies is 0.7.
- Cross-country differences are described as considerable.
- A referenced top-third FISCO level is about 0.8.
Conceptual notes:
- The FISCO accounts for the fact that many revenue and expenditure items respond to the state of the economy even if they were designed for other reasons.
- Monitoring the relationship between the budget balance and the output gap helps policymakers understand how much their action contributes to output stability and allows cross-country comparisons.

Mechanism:
- Higher FISCO → lower macroeconomic volatility → reduced wasteful fluctuations in employment and growth.
- Lower macroeconomic uncertainty → more favorable environment for physical and social capital → higher medium-term growth.
Quantified example:
- An advanced economy raising its FISCO from the average level (0.7) to that in the top third of countries (about 0.8) would:
- Reduce output volatility by about 15 percent.
- Deliver a growth dividend of 0.3 percentage points annually.
Methodology and caveats:
- The Fiscal Monitor provides greater details of the methodology, which attempts to address known challenges with growth regressions.
- Findings should be interpreted with caution, as with all econometric results.

Strengthening fiscal frameworks:
- Put in place a fiscal framework to manage public finance risks.
- Implement well-designed fiscal rules and medium-term frameworks to:
- Enable uninterrupted access to borrowing at favorable conditions.
- Ensure expenditure control over the entire cycle.
- Leave flexibility to respond to output shocks.
Promote automatic stabilizers:
- Induce rules-like, automatic stabilizing responses to economic developments (e.g., tax payments that move with income, social transfers such as unemployment benefits).
- Rationale: Automatic stabilizers operate in real time without political approval or implementation lags, making them an effective way to make fiscal policy stabilizing.

Measure to Measure: The Effect of Fiscal Policy on Growth and Stability — Vitor Gaspar, April 15, 2015

Now Is the Time: Fiscal Policies for Sustainable Growth, Fiscal Monitor, April 2015
- Now Is the Time: Fiscal Policies for Sustainable Growth, Fiscal Monitor, April 2015 (Markdown version)
- Now Is the Time: Fiscal Policies for Sustainable Growth, Fiscal Monitor, April 2015 (PDF)