Thursday, March 10, 2011

Country specific effects of fiscal stimulus

Ethan Ilzetzki, Enrique Mendoza, and Carlos Vegh (2011) analyze a quarterly dataset on government expenditures for 44 countries (20 high-income and 24 developing) from 1960 to 2007 and argue that the impact of government fiscal stimulus depends on key country characteristics:

  1. The output effect of an increase in government consumption is larger in industrial than in developing countries. Only after a lag of two to four quarters does output rise in response to an increase in government consumption, and the cumulative output response is not statistically different from zero. Furthermore, increases in government consumption are less persistent (dying out after approximately six quarters) in developing countries than in high-income countries. But, only in developing countries is the multiplier on government investment significantly higher than the multiplier on government consumption. Thus, the composition of expenditure may play an important role in assessing the effect of fiscal stimulus in developing countries.
  2. The fiscal multiplier is relatively large in economies operating under predetermined exchange rate but zero in economies operating under flexible exchange rates.The differences in the responses to increases in government consumption in countries with fixed and flexible exchange rate regimes are largely attributable to differences in the degree of monetary accommodation to fiscal shocks in these nations. The results imply that the central banks' response to fiscal shocks is crucial in assessing the size of fiscal multipliers.
  3. Fiscal multipliers in open economies are lower than in closed economies. Economies that are relatively closed, whether because of trade barriers or larger internal markets, have long-run multipliers of around 1.3 to 1.4, but relatively open economies have negative multipliers.
  4. Fiscal multipliers in high-debt countries are also zero. When the outstanding debt of the central government exceeds 60 percent of GDP, the fiscal multiplier is not statistically different from zero on impact and it is negative in the long run.

This might mean that in a least developed country like Nepal, the government can do a lot to jack up growth rate. First, government investment has to be high as consumption level is already high in Nepal. This means investment in infrastructures, education, health and research & technology. Second, since Nepal has a fixed exchange rate with India, and if the central bank rolls out monetary policy that is consistent with fiscal stimulus, the resulting fiscal multiplier could be large. Also, given the idle resources and massive unemployment, fiscal stimulus (with good governance on the use of money) would produce sizable impact on the economy.

About, high-debt argument, Krugman disagrees with the 60 percent of GDP threshold (Reinhart-Rogoff argue that debt over 90 percent of GDP leads to drastically slower growth. Krugman dismisses this idea.)