Academic journal article Contemporary Economic Policy

Fiscal Multipliers during the Global Financial Crisis: Fiscal and Monetary Interaction Matters

Academic journal article Contemporary Economic Policy

Fiscal Multipliers during the Global Financial Crisis: Fiscal and Monetary Interaction Matters

Article excerpt

I. INTRODUCTION

In the wake of the 2007-2009 global financial crisis (GFC), most developed economies implemented expansionary fiscal policies at record levels as a countermeasure for the economic downturn. However, there is no consensus regarding the effectiveness of the policies, and the debate on the size of fiscal multipliers is ongoing. (1) Furthermore, the economic consequences of fiscal policy are being highlighted from a different angle to determine the size of the economic effects of fiscal consolidation. Because the government debt levels of major economies, including the United States, the United Kingdom, Germany, and France, have soared to record levels, these countries are under strong pressure of fiscal retrenchment. Therefore, Blanchard and Leigh (2013) warn that the fiscal contraction plans these countries implement may lead to a lower-than-expected level of economic growth.

In this paper, we investigate the fiscal-multipliers of 21 advanced countries during the GFC. We find that the 1-year fiscal multiplier was greater than 1 during the crisis, whereas it was less than I before the crisis. The differences among the multipliers are caused by the interactions between fiscal and monetary policy. In normal economic times, contractionary monetary policy tends to follow expansionary fiscal policy, which mars the effectiveness of the fiscal expansion both internally and externally: If a monetary authority increases the interest rate as a response to expected inflation caused by fiscal expansion, private investment shrinks (i.e., it is crowded-out), which we denote as the internal transmission channel of the policy mix. Moreover, the increased interest rate causes a real exchange rate appreciation, in turn retrenching net exports, which is the external transmission of the policy mix. By contrast, during the crisis, expansionary fiscal policy combined with expansionary monetary policy led to a countering of the crowding-out effects by lowering the policy interest rate, as was the case of most advanced economies' macroeconomic policy combinations during the GFC. Our results empirically confirm the internal and external transmission channels of policy interactions; therefore, large-scale fiscal expansions with expansionary monetary policy during the GFC were an effective policy choice.

On one hand, the literature has focused on the Mundell-Fleming theory to explain various magnitudes of fiscal multipliers in terms of policy interactions. The traditional view of the Mundell-Fleming theory proposes that a fixed-exchange regime requires an accommodating monetary policy in response to fiscal expansion to maintain the exchange rate. The combination of both expansionary fiscal and monetary policy in a fixed regime amplifies the fiscal multipliers to a degree larger than those of a floating-exchange regime. Recently, a growing body of literature has examined fiscal multipliers empirically using a panel vector auto regression (VAR) model, which has validated the Mundell-Fleming theory. Ilzetzki, Mendoza, and Vegh (2013) (hereafter IMV) investigate the issue using 44 developing and developed countries between Q 1 1960 and Q4 2007. IMV test several hypotheses for the size of the multipliers and find that a country with a fixed exchange-rate regime has a relatively high fiscal multiplier, whereas one with a floating regime has a close-to-zero multiplier. Corsetti, Meier, and ller (2012) (hereafter CMM) explore the fiscal multipliers using a sample of 17 Organization for Economic Co-operation and Development (OECD) advanced economies for the period 1975-2008. CMM find higher multipliers for pegged exchange-rate regimes, but in their results, when a country with a pegged exchange-rate regime increases government consumption, monetary policy becomes less accommodating and the real exchange rate appreciates, which is not consistent with the Mundell-Fleming theory. Finally, Born, Juessen, and Muller (2013) reaffirm that fiscal multipliers are considerably larger under a fixed exchange-rate regime, using semiannual OECD country data from 1986 to 2011. …

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