On the Identification of Fiscal Policy Behavior

Abstract:     
In the current literature, fiscal policy is usually characterized by a single-equation rule, in which primary surplus is generally defined as a function of lagged government debt and other controlled variables. To apply Ordinary Least Squares (OLS) method on the single-equation rule has been one of the common approaches to identify fiscal policy behavior. From the rational expectations general equilibrium perspective, this paper illustrates that lagged government debt is generally endogenous and the OLS approach suffers from simultaneity bias. Consequently, the OLS-based identification of fiscal policy behavior is unreliable. As a solution, we apply the Generalized Method of Moments (GMM) for estimation and inference. Monte Carlo experiments demonstrate that GMM provides more reliable results than OLS in terms of accuracy of the estimator, size and power. In short, people should be cautious of the existing OLS-based identification results of fiscal policy behavior and the empirical researchers should not consider OLS regression as a reliable tool when trying to identify fiscal policy behavior in the future.

Keywords: Fiscal Policy Rule, Non-Ricardian, Ricardian, Simultaneity Bias, OLS, GMM, Size, Power

JEL Classification: C12, C13, E63

working papers series