Working Paper No. 8: Fiscal Policy in General Equilibrium: an analysis applied to the euro area
This paper aims to rationalize and evaluate scal stimulus and adjustment in a general equilibrium model applied to the euro area as a function of the speed and composition of the adjustment. Literature concerning scal policy in general equilibrium has not treated this approach, by favoring lump-sum taxation and by examining the level of persistence of the stimulus. Based on a neokeynesian model in an open economy, with detailed social instruments that react to public debt dynamics, several results can be drawn.
First, recent studies present sensitive results because the speed of scal adjustment is taken as given. The growth in private consumption following an increase in public spending, which Corsetti et al. (2012) show, can only be reproduced using a fast rate of adjustment.
Second, the eff ectiveness of stimulating production depends to a large extent on the social expansion instrument used. The most important multipliers, greater than one, are those related to public investment, followed by public consumption and transfers to fi nancially constrained households. In the short-run, the expansion of these three instruments is a self-fi nancing process, with decreasing debt (as a ratio of production) due to increases in tax bases and output growth. By contrast, tax cuts favoring the supply-side have smaller e ffects on output. If demand were to shrink because of lower public spending, these eff ects would decrease even more.
Third, even though the anticipation of an accelerated adjustment after a stimulus were to have positive e ffects on output in the short-run through lower interest rates, the negative e ffects on the demand-side dominate in the medium term. In the case of an accelerated adjustment, the negative impact on production will be weaker if revenues have a larger share in the total adjustment. Finally, the composition of the adjustment plays a smaller role on the production when the adjustment is gradual.
- Classiffication: JEL: E62, E63, F41
- Keywords: fiscal policy, fiscal stimulus, distortionary taxation, fiscal multiplier, neokeynesian model
- Author: Thomas Brand, Departement of Economic and Financial Affairs
- No. 2012-03, June 2012