Output Spillovers from Fiscal Policy

TL;DR: In this article, the cross-country spillover effects of government purchases on output for a large number of OECD countries were estimated and shown to have an important impact, and also confirm those of our earlier papers that fiscal shocks have a larger impact when the affected country is in recession.

Abstract: In this paper, we estimate the cross-country spillover effects of government purchases on output for a large number of OECD countries. Following the methodology in Auerbach and Gorodnichenko (2012a, b), we allow these multipliers to vary smoothly according to the state of the economy and use real-time forecast data to purge policy innovations of their predictable components. We also consider the responses of other key macroeconomic variables. Our findings suggest that cross-country spillovers have an important impact, and also confirm those of our earlier papers that fiscal shocks have a larger impact when the affected country is in recession.

Summary

1. Introduction

• One of the challenges facing a country attempting to maintain economic stability is the economic shocks emanating from abroad, which through trade and other linkages may have important effects on domestic conditions.
• In a recent paper, Hebous and Zimmermann (2012) adopt a panel VAR approach to estimate the effects of domestic and foreign fiscal shocks among Eurozone countries, representing foreign shocks as a common, GDP weighted aggregate of the individual country shocks.
• This allows us to consider, for example, the differences in effects among countries sharing fixed exchange rates versus those that do not.
• Finally, the authors consider the effects of fiscal spillovers not only on output but also on a number of other macroeconomic variables; hence they can paint a more detailed picture of how fiscal shocks propagate across countries.

2. Modeling Fiscal Spillovers

• To model the effects of fiscal spillovers, the authors extend the approach taken in Auerbach and Gorodnichenko (2012b) and use data for a panel of OECD countries to estimate fiscal spillover multipliers using direct projections.
• First, variables in equation (1) are in differences, scaled by lagged GDP, which follows the approach in Hall (2009) and Barro and Redlick (2011).
• While the analysis of the effects of such shocks was the main objective of their previous papers, including them here would require a significant reduction in sample size, for there are many country-years for which the authors do not have OECD forecasts of government spending.
• Thus, 𝐺𝑆ℎ𝑜𝑐𝑘𝑖,𝑡 is the weighted average percent shock in government spending in other countries scaled by the level of imports from country i. Equation (2) uses fixed, base-year exchange rates and import intensity for scaling fiscal shocks.
• In some instances, the authors prefer using equation (1’’) with 𝐺𝑆ℎ𝑜𝑐𝑘𝑖𝑡.

3. Data

• The macroeconomic series the authors use in their analyses come from the OECD’s Statistics and Projections database.
• The OECD’s forecasts are consistently available since 1984 for “old” members of the OECD (e.g., the United States) and since the mid-1990s for newer members (e.g., Poland).
• To avoid a further reduction in sample size, as discussed above, the authors omit owncountry fiscal shocks from their specification, in order to include observations for countries in years for which their own forecasts of government purchases are unavailable.
• For all model specifications presented below, the authors estimate impulse responses for six semiannual periods, starting in the first half of 1985 (because their projections of government spending are available beginning in 1984).
• The correlation of shock series across countries varies between -0.4 to 0.99 with the mean correlation of approximately 0.4.

4. Results

• Table 2 presents results for a variety of specifications based on the approach outlined above.
• The remaining columns of Table 2 show estimates of state-dependent multipliers, based on economic conditions in the recipient country, i, from expression (4), using their three different measures to represent the state of the business cycle, based on output growth, log output level, and the unemployment rate.
• All components of output rise more in recession, as does employment.
• More generally, the authors would expect the transmission of shocks to differ between fixed and floating exchange rate regimes, ceteris paribus, because changes in a source country’s demand for imports would not have the same effects on its exchange rates vis à vis its trading partners.
• But it is also possible that the relationship between the external shock and the source country’s fiscal shock might depend on that country’s economic conditions.

5. Conclusions

• In an increasingly globalized world, policies adopted in one country are likely to affect economic outcomes in other countries.
• To what extent, if at all, fiscal policies spill over into other countries is a key question in the current environment with depressed economies and high or rising levels of public debt in many developed countries.
• The authors document that fiscal stimulus in one country is likely to have economically and statistically significant effects on output in other countries.
• Furthermore, the strength of the spillover varies with the state of the economy in the recipient and source countries, with the output multipliers being large in recessions.
• This approach is likely to provide a solid, empirically plausible foundation for designing fiscal policies.

Figures

Table 5. Average output multipliers over 3 years by exchange rate regime and by business cycle regime

Figure 1. Time series of fiscal spillover shocks for selected countries

Table 1. Descriptive statistics

Table 2. Average output multipliers over 3 years

Table 3. Additional macroeconomic variables: average multipliers over 3 years

Figure 2. Impulse response functions (fixed weights)

Table 4. Average output multipliers over 3 years by exchange rate regime

Full text

NBER WORKING PAPER SERIES
OUTPUT SPILLOVERS FROM FISCAL POLICY
Alan J. Auerbach
Yuriy Gorodnichenko
Working Paper 18578
http://www.nber.org/papers/w18578
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
November 2012
Alan Auerbach acknowledges the Robert D. Burch Center for research support, and has no material
outside financial relationships that may relate to this research. Yuriy Gorodnichenko acknowledges
the National Science Foundation for research support, and has no material outside financial relationships
that may relate to this research. This paper will be presented at the American Economic Association
meetings, San Diego, January 2013. We thank Olivier Coibion for comments on an earlier version
of the paper. We are grateful to Kyle Kennelly for research assistance. The views expressed herein
are those of the authors and do not necessarily reflect the views of the National Bureau of Economic
Research.
NBER working papers are circulated for discussion and comment purposes. They have not been peer-
reviewed or been subject to the review by the NBER Board of Directors that accompanies official
NBER publications.
© 2012 by Alan J. Auerbach and Yuriy Gorodnichenko. All rights reserved. Short sections of text,
not to exceed two paragraphs, may be quoted without explicit permission provided that full credit,
including © notice, is given to the source.

Output Spillovers from Fiscal Policy
Alan J. Auerbach and Yuriy Gorodnichenko
NBER Working Paper No. 18578
November 2012
JEL No. E32,E62
ABSTRACT
In this paper, we estimate the cross-country spillover effects of government purchases on output for
a large number of OECD countries. Following the methodology in Auerbach and Gorodnichenko
(2012a, b), we allow these multipliers to vary smoothly according to the state of the economy and
use real-time forecast data to purge policy innovations of their predictable components. We also consider
the responses of other key macroeconomic variables. Our findings suggest that cross-country spillovers
have an important impact, and also confirm those of our earlier papers that fiscal shocks have a larger
impact when the affected country is in recession.
Alan J. Auerbach
Department of Economics
530 Evans Hall, #3880
University of California, Berkeley
Berkeley, CA 94720-3880
and NBER
auerbach@econ.berkeley.edu
Yuriy Gorodnichenko
Department of Economics
508-1 Evans Hall #3880
University of California, Berkeley
Berkeley, CA 94720-3880
and NBER
ygorodni@econ.berkeley.edu

1. Introduction
One of the challenges facing a country attempting to maintain economic stability is the economic
shocks emanating from abroad, which through trade and other linkages may have important
effects on domestic conditions. While such shocks may have many sources, one of particular
interest is fiscal policy. Indeed, a common justification for fiscal agreements like the Stability
and Growth Pact and successive measures adopted by Eurozone countries is that, having
relinquished independent monetary and exchange rate policies, individual countries need some
protection from the shocks of uncoordinated fiscal policies. Economic observers long
appreciated the importance of fiscal spillovers but it is the current economic environment of ever
increasing globalization and of conflicting calls for fiscal austerity and fiscal stimuli that
demands clear and robust evidence to navigate policymakers through the Great Recession and its
aftermath. Specifically, there are at least three key questions: (1) What is the effect of fiscal
austerity/stimulus in one country on economic conditions in another country? (2) Can countries
short of fiscal ammunition (e.g., Greece during the Great Recession) be supported by positive
fiscal stimulus in other countries? (3) Does the strength of fiscal spillovers vary over the business
cycle? If so, what should be the scope of coordinated fiscal policies in recession? In this paper,
we try to shed new light on these questions, with results that have a number of immediate policy
implications.
Our paper is certainly not the first empirical investigation of fiscal spillovers. For
example, Bénassy-Quéré and Cimadomo (2006) estimate the impact of fiscal spillovers from
Germany to the remaining G-7 countries using an augmented SVAR model. Beetsma et al.
(2005) estimate the spillover impact of shocks via the trade channel by combining panel VAR
estimates of the effects of domestic shocks on output and estimates of the effects of output on

2
imports from abroad. In a recent paper, Hebous and Zimmermann (2012) adopt a panel VAR
approach to estimate the effects of domestic and foreign fiscal shocks among Eurozone
countries, representing foreign shocks as a common, GDP weighted aggregate of the individual
country shocks.
1
We extend the existing literature in a number of ways. First, we consider fiscal spillovers
among OECD countries, a larger and more heterogeneous group than the G-7 or the Eurozone.
This allows us to consider, for example, the differences in effects among countries sharing fixed
exchange rates versus those that do not. Second, although we allow shocks to depend on trade
linkages, we directly estimate the effects of shocks in one country on another country’s output.
This makes interpretation of estimated coefficients in our econometric specification particularly
straightforward and transparent. Third, we allow multipliers to vary across states of the business
cycle, thus relaxing standard assumptions that our previous analysis of domestic shocks in the
United States and the OECD (Auerbach and Gorodnichenko, 2012a, b, respectively) suggested
was important. Fourth, we enhance identification of fiscal shocks by removing predictable
innovations in government spending by controlling for information contained not only in the lags
of macroeconomic variables but also in professional forecasts. This aspect is important because
anticipated and unanticipated fiscal shocks may have different effects and mixing these two
types of shocks, which is likely to happen in VAR models (see e.g. Ramey 2011 and Auerbach
and Gorodnichenko 2012a, 2012b), can lead to understating estimated effects of fiscal shocks.
Finally, we consider the effects of fiscal spillovers not only on output but also on a number of
other macroeconomic variables; hence we can paint a more detailed picture of how fiscal shocks
propagate across countries.
1
There have also been a number of papers estimating the impact of fiscal spillovers using DSGE models. See, for
example, Bénassy-Quéré (2006) and Corsetti, Meier, and Müller, (2010).

3
We document that fiscal spillovers are significant in both statistical and economic terms.
The effect, however, varies tremendously over the business cycle with the spillovers being
particularly high in recessions and quite modest in expansions, with the output multiplier in
recessions being even larger than those found in our previous work for domestic shocks, based
on what would expect given the strength of trade linkages. We also find that fiscal spillovers are
increased further when both recipient and source countries are in recession.
2. Modeling Fiscal Spillovers
To model the effects of fiscal spillovers, we extend the approach taken in Auerbach and
Gorodnichenko (2012b) and use data for a panel of OECD countries to estimate fiscal spillover
multipliers using direct projections. Specifically, for our baseline model we run a series of
regressions for different horizons, h = 0, 1, …, H of the form:
(1)

,

,

,
= 




,
+




,

,


+




,

,


+ 

+ 

+ 

where  and  index time and countries, Y is real GDP, and G is real government purchases (both
Y and G are measured in terms of local currency in fixed prices of the base year),  and  are
horizon-specific country and time fixed effects, and  is the government spending
spillover shock emanating from other countries, which we will specify further. The impulse
response for  periods is constructed from a sequence of estimated
{


}


.
Before we continue, a few observations about equation (1) are useful. First, variables in
equation (1) are in differences, scaled by lagged GDP, which follows the approach in Hall (2009)
and Barro and Redlick (2011). Estimated
{


}


in this specification directly correspond to
multipliers while in our previous work we estimated elasticities of output with respect to a