Stochastic Trends, Debt Sustainability and Fiscal Policy

IMF Working Papers, March 10, 2016

Source details

Study objective: Empirically assess the reaction of fiscal policy to changes in the permanent and transitory components of GDP in a panel of countries.
Main empirical findings:
- Government spending tends to be counter-cyclical conditional on temporary shocks.
- Government spending tends to be pro-cyclical conditional on permanent shocks.
- No evidence that developing countries are systematically different from developed ones in terms of fiscal policy.
Theoretical contribution: A theory featuring a fiscal reaction function to the output gap and a measure of debt sustainability.
Fiscal impulse responses:
- Response to a permanent shock to GDP: positive (effect on debt sustainability dominates).
- Response to a temporary shock to GDP: negative (effect on current output gap dominates).

Fiscal cyclicality:
- Counter-cyclical response when shocks are transitory.
- Pro-cyclical response when shocks are permanent.
Cross-country patterns:
- No systematic distinction between developing and developed countries in fiscal reaction patterns reported.
Key conceptual link:
- The sign and magnitude of fiscal responses depend on whether the shock affects debt sustainability more strongly (favors positive response) or the current output gap more strongly (favors negative response).

Core elements:
- Fiscal reaction function that responds to the output gap.
- Incorporated measure of debt sustainability that influences fiscal decisions.
Mechanism:
- A permanent positive GDP shock improves debt sustainability, inducing a positive fiscal impulse (higher spending).
- A temporary positive GDP shock reduces the current output gap pressure, inducing a negative fiscal impulse (lower spending).

Results are mostly sensitive to:
- The relative weight of debt sustainability in the fiscal reaction function.
- The extent of real rigidities in the economy.
Implication: Policy conclusions depend critically on how policymakers trade off debt sustainability versus output gap stabilization and on structural features affecting the transmission of shocks.

Stochastic Trends, Debt Sustainability and Fiscal Policy — IMF Working Paper by Karim Barhoumi, Reda Cherif, and Nooman Rebei (March 10, 2016).