An overview of the book: Fiscal Policy and Macroeconomic Performance from the Central Bank of Chile

After two decades of relative neglect, fiscal policy is back at the center of the economics research agenda. The fiscal developments around the global financial crisis of 2007-2009 and its aftermath are undoubtedly a major factor behind that comeback. The large fiscal stimulus packages adopted by many countries in the face of large adverse shocks have triggered an unusually heated debate among academics, policymakers and commentators alike.

In ten contributions written by economists with a recognized expertise in the field, this book shed light on the key questions at the aftermath of crises: How effective is fiscal policy at stimulating the economy? What is the best design for a fiscal stimulus package? Should it put most of its weight on government spending increases or on tax reductions? Are automatic stabilizers enough or is a discretionary stimulus needed? How does fiscal policy interact with monetary policy? Is there room for coordination? What are the possible consequences for the economy of a large rise in the debt/GDP ratio? And those of the fiscal consolidations aimed at stabilizing that ratio? Finally, should countries adopt explicit fiscal rules?

These contributions were presented during the Fourteenth Annual Conference of the Central Bank of Chile, on Fiscal Policy and Macroeconomic Performance. They were organized into three sections.

The first assessed the effects of fiscal policy on macroeconomic outcomes. Tommaso Monacelli, Roberto Perotti, and Antonella Trigari focused on the effects of tax cuts on the labor market. Which is more effective at reducing unemployment—increasing government spending or reducing taxes? They show that an increase in tax receipts of one percent of GDP has a sizeable positive impact on the unemployment rate and a negative impact on hours worked, labor market tightness, and the probability of finding a job. The negative effect on GDP depends on a series of methodological details. Finally, they also show that the unemployment multiplier is larger for business taxes than for personal income taxes.

Joachim Voth analyzed the extent to which fiscal retrenchment can take place before civil unrest is triggered. Using data of a group of South American countries, he constructs a measure called chaos based on data collected by Banks (1994) on the number of political assassinations, general strikes, riots, and anti-government demonstrations. Voth finds strong evidence that fiscal austerity is associated with periods of violent protest. Surprisingly, increases in fiscal revenues have a similar effect to expenditure changes. This may be explained by episodes of simultaneous tax and spending increases that reduce the level of unrest.

Rodrigo Caputo and Miguel Fuentes examined the long-run effects of fiscal transfers and investment on the real exchange rate (RER) in a broad panel of countries for the period 1980–2007. In addition to considering the impact of government consumption on the RER, they analyze the effect of the other two components of fiscal expenses. Their results suggest that changes in both government consumption and public investment appreciate the RER significantly, with the long-run elasticity being close to one. They also find that government transfers appear to have no impact on the RER.

Finally, Mauricio Villafuerte, Pablo López-Murphy, and Rolando Ossowski presented a cyclicality examination of fiscal policies among resource exporters countries—namely Bolivia, Chile, Ecuador, Mexico, Peru, Trinidad and Tobago, and Venezuela. For these countries, fiscal revenues from nonrenewable sources represented between 20 and 57 percent of total fiscal revenues in 2005–09. The authors argue that fiscal policy was predominantly procyclical in these countries during the boom. Also, in the 2009 downturn, some countries implemented a countercyclical fiscal policy, while others experienced a procyclical stance.

The second section included research on the interactions of fiscal and monetary policy. Gauti Eggertsson analyzed how the fiscal multiplier is affected by the degree of coordination between the fiscal and monetary authorities. Using a standard New Keynesian economy subject to the zero lower bound on the nominal interest rate and with costly taxation, he shows that the coordination of fiscal and monetary policy is key for increasing the credibility of future inflation announcements. If raising taxes is costly, inflation may be a good alternative for reducing public debt. The announcement of future inflation supported with increases in government spending can be highly credible if the central bank shares, to some extent, the government’s objective function (coordination). In this case, the deficit spending multiplier is high, which adds to the classical real government spending multiplier.

Giancarlo Corsetti, Keith Kuester and Gernot Müller questioned the conventional wisdom that fiscal policy is more expansionary under a fixed exchange rate than under a floating regime. They argue that it depends crucially on the medium-term fiscal regime under consideration. They consider a fiscal regime in which, after an initial fiscal stimulus, both spending and taxes are adjusted so as to stabilize debt. In this case, the long-term real interest rate tends to fall if agents anticipate a contraction in government spending in the near future. As this is expected to cause a slowdown of inflation, under floating rates private agents also expect the central bank to cut policy rates. In this scenario, long-term real interest rates may actually fall at the time of the fiscal expansion, instead of increasing. Thus, the conventional wisdom does not hold.

Luis Felipe Céspedes, Jorge Fornero, and Jordi Galí explored the effects of Chilean fiscal policy on consumption and income using a DSGE framework that relaxes the assumption of Ricardian equivalence. They centered on the effects of government spending shocks. The positive consumption multiplier that emerges from their empirical analysis suggests the presence of non-Ricardian effects. They show that the specification of a fiscal policy rule that approximates the Chilean rule leads to consumption and output fiscal multipliers that are positive in the short run, in a way consistent with the evidence.

The final section focused on fiscal policy in emerging market economies. Jeffrey Frankel discussed the structural spending rule adopted by Chile in 2001 in order to explain its distinctive behavior compared to other Latin American commodity exporters. Fiscal policy in Chile is implemented using a structural balance rule. Under this rule, if effective copper prices are above the long-run trend or if the economy is in a boom, the government must save the difference generated in fiscal revenues. Frankel provides evidence that official forecasts will generally be overly optimistic if not insulated from politics, and the problem can be worse when the government is formally subject to budget rules. He argues that the key innovation that has allowed Chile to achieve countercyclical fiscal policy and to run surpluses in booms is not the structural budget rule itself, but the creation of a regime that transfers the responsibility for estimating long-run trends in copper prices and GDP to independent expert panels.

Eduardo Engel, Christopher Neilson, and Rodrigo Valdés presented a welfare analysis of the effects of Chile’s fiscal rule. The authors study the optimal design of the spending rule for a government that has volatile revenues from an exogenous source, such as a flow from a natural resource. Crucially, the government has limited space for borrowing against future revenue and has access to an imperfect technology for targeting transfers, such that a fraction of the transfers go to richer households. The authors concentrate on the implementation of social insurance, showing that the gains from moving from a balanced budget rule to an optimal rule are significant. Optimal spending is countercyclical, and this countercyclicality is higher when government expenditures are less targeted because the inefficiencies of poor targeting are less costly. Simpler rules, such as the structural balance rule, also provide welfare gains.

Finally, Michel Strawczynski and Joseph Zeira examined the cyclicality of fiscal policy in a broad set of emerging market economies and assessed whether the observed dynamics can be characterized using Aguiar and Gopinath’s (2007) distinction of permanent and temporary shocks. Finally, institutions may play a significant role explaining the procyclicality of fiscal policy in Latin America. The authors study a different channel that may explain this behavior: the characteristics of business cycles in these economies. They test whether developed and emerging economies react differently to persistent shocks to output. Their results indicate that while government expenditure in developed economies is not affected by permanent shocks, emerging countries tend to implement a procyclical fiscal policy when facing permanent shocks to per capita GDP.