Government Spending Effects in a Policy Constrained Environment

IMF Working Papers, June 12, 2020

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Government Spending Effects in a Policy Constrained Environment

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Bibliographic details

• Authors: Ruoyun Mao, Shu-Chun Susan Yang
• Published: June 12, 2020
• Series: IMF Working Papers

Summary

• The theoretical literature generally finds that government spending multipliers are bigger than unity in a low interest rate environment.
• Using a fully nonlinear New Keynesian model, the paper shows that such big multipliers can decrease when:
  • an initial debt-to-GDP ratio is higher,
  • tax burden is higher,
  • debt maturity is longer,
  • monetary policy is more responsive to inflation.
• When monetary and fiscal policy regimes can switch, policy uncertainty also reduces spending multipliers.
• In particular, when higher inflation induces a rising probability to switch to a regime in which monetary policy actively controls inflation and fiscal policy raises future taxes to stabilize government debt, the multipliers can fall much below unity, especially with an initial high debt ratio.
• The findings help reconcile the mixed empirical evidence on government spending effects with low interest rates.

Key Findings and Mechanisms

• Government spending multipliers may be greater than 1 in low interest rate settings (baseline theoretical result).
• Multipliers decrease under the following conditions:
  • Higher initial debt-to-GDP ratio.
  • Higher tax burden.
  • Longer debt maturity.
  • More responsive monetary policy to inflation.
• Regime-switching (monetary and fiscal) introduces policy uncertainty that reduces multipliers.
• A mechanism: higher inflation increases the probability of switching to a regime where:
  • monetary policy actively controls inflation, and
  • fiscal policy raises future taxes to stabilize government debt,

leading multipliers to fall much below unity, especially with a high initial debt ratio.

Policy Implications

• The effectiveness of government spending as a stimulus is conditional on fiscal and monetary positions and on policy regime stability.
• Policymakers should consider:
  • current debt-to-GDP ratios when evaluating fiscal stimulus multipliers,
  • existing tax burdens and the implications for multiplier size,
  • debt maturity structures and their impact on fiscal space,
  • monetary policy reaction functions (responsiveness to inflation) and how they interact with fiscal measures,
  • the role of policy uncertainty and regime-switching expectations in reducing fiscal multipliers.

Publication and Metadata

• Authors: Ruoyun Mao, Shu-Chun Susan Yang
• Date: June 12, 2020
• Pages: 44
• Volume: 2020
• Issue: 091
• Series: Working Paper No. 2020/091
• Stock No: WPIEA2020091
• ISBN: 9781513546797
• ISSN: 1018-5941
• Subjects: Consumption, Expenditure, Financial services, Inflation, National accounts, Prices, Public debt, Real interest rates, Zero lower bound
• Keywords: Consumption, fiscal multiplier, fiscal policy, fiscal policy interaction, Global, government spending effect, government spending effects, government spending increase, government spending multiplier, Inflation, monetary, nominal interest rate, nonlinear New Keynesian models, output multiplier, policy uncertainty, Real interest rates, regime F, regime-switching policy, WP, Zero lower bound

Source: IMF Working Papers — "Government Spending Effects in a Policy Constrained Environment" (Working Paper No. 2020/091) by Ruoyun Mao and Shu-Chun Susan Yang, June 12, 2020.

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