Effectiveness of Fiscal Policy in the U.K. during the 1960-1990 Time Period

By Saunders, Peter J. | Indian Journal of Economics and Business, March 2006 | Go to article overview
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Effectiveness of Fiscal Policy in the U.K. during the 1960-1990 Time Period


Saunders, Peter J., Indian Journal of Economics and Business


Abstract

This study investigates the impact of fiscal policy on the U.K. economy during the 1960 - 1990 time period. The empirical analysis is conducted within the Granger causality testing methodology. Initially the causal flows between fiscal expenditures, deficits and nominal GDP are examined. A hi-directional causal flow between expenditures and nominal GDP is established while deficits and nominal GDP are found to be statistically independent. However, the main contribution of this research lies in its emphasis on analyzing the impact of fiscal expenditures on real output and prices. The results of the trivariate analysis indicate the absence of causal flows from fiscal expenditures to real GDP while the U.K. economy's prices appear to be causally affected by these expenditures.

Introduction

One of the key postulates of standard Keynesian economic theory concerns the impact of fiscal policy on national output and the employment level. It is explicitly assumed that expansionary fiscal policy exerts a positive impact on an economy's output and level of employment. (1) This theoretical proposition has been tested empirically. One of the first serious empirical challenges to the standard view of the effectiveness of fiscal policy was presented by Andersen and Jordan (1968) in their now well known St. Louis model. Andersen and Jordan's findings cast serious doubt on the effectiveness of fiscal policy in economic stabilization. A further empirical investigation of the impact of fiscal policy on the U.S. economy was undertaken by Hafer (1982). This study was partially designed to reassess the role of fiscal policy while maintaining some of the testing framework of the original St. Louis model. The study was conducted within the Granger (1969) causality testing methodology. According to Hafer, fiscal policy has no lasting or statistically significant impact on nominal GDP growth in the U.S.

The above studies indicate that the standard postulated relationship between expansionary fiscal policy and its subsequent effect on output may not be supported by empirical evidence. However, given the importance of fiscal expenditures in economic theory and policy, further empirical research into the effects of fiscal policy is desirable. The purpose of this study is to undertake such a task. The investigation is conducted within the Granger (1969) causality testing framework. The U.K. data are analyzed to determine if fiscal expenditures and deficits have had a statistically significant causal impact on output in the U.K. The empirical evidence presented for the U.K. can supplement the U.S. studies by providing further important information on the impact of fiscal policy on an economy.

The effects of fiscal policy on an economy can be investigated by analyzing the existence and strength of empirical relationships between some measures of fiscal policy and nominal output. This is the standard approach to analyzing the effectiveness of fiscal policy [Andersen and Jordan (1968), Hafer (1982)]. Granger (1969) causality testing framework provides a useful empirical tool for such an undertaking. It allows an examination of causal relationship between any two variables, such as fiscal expenditures and nominal GNP [Hafer (1982)]. However, the standard approach to investigating the effects of expenditure changes on nominal GDP is incomplete. It only indicates the existence or absence of causal flows from fiscal expenditures to nominal GNP. Since nominal GDP comprises of the price component and the real output component, one is left guessing whether fiscal expenditures affect only real GDP, or prices, or both. Successful fiscal stabilization policy requires that fiscal expenditures impact an economy's real output and, thereby, its employment level. Consequently, the focus of an empirical investigation should be on the effects of fiscal policy on the two components of nominal output, namely prices and real output.

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