June 7, 2019

Estimating the Impact of the Financial Cycle on Fiscal Policy

We investigate the impact of the financial cycle on the effectiveness of fiscal policy. We find that government investment becomes substantially more effective during a downturn in the financial cycle, whereas during an upturn we obtain negative multipliers.
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Our contribution to the existing literature is three fold. First, we estimate fiscal multipliers that depend on different states of the financial cycle, wich are estimated by CPB in Estimates of the Financial Cycle for Advanced Economies. Second, to obtain our estimates we extend the TVAR method from a single country to a panel. Third, we investigate the fiscal multipliers of different types of government spending. We find that the multipliers for government investment are influenced substantially by the state of the financial cycle. In an upturn they are negative, while in a downturn they are positive. When we also condition on the state of the business cycle our results for government investment remain essentially unchanged. We obtain smaller multipliers for government consumption. Although these multipliers do not depend on the financial cycle, jointly conditioning on the financial and business cycles does produce multipliers which vary over the states of both cycles.