Fiscal Policy and the Business Cycle: A New Approach to Identifying the Interaction

Abstract

Murchison and Robbins present an innovative procedure to jointly estimate an indicator of fiscal impact or, equivalently, of the Fiscal Policy Stance (FiPS), and an indicator of the cyclically adjusted budget balance. The procedure is based on the simultaneous estimation of a set of fiscal equations where changes in the main budgetary items are related to changes in the output gap, and of an output equation where changes in the output gap are related to movements in the same budgetary items and in a set of other exogenous determinants. In order to identify the fiscal and the output equations and to control for the simultaneity bias, a generalised method of moments estimator is used. The authors point out that their indicator is more appropriate for the assessment of the fiscal policy stance (in its original meaning, that is “the impact of the budget on the economy”) than the widely used cyclically adjusted budget balance which does not allow for heterogeneous effects on demand across the components of the budget and disregards the impact of automatic stabilisers. An important feature of the procedure is that it allows to derive a measure of the uncertainty surrounding the estimates. However, a number of issues, also common to other indicators, suggest a cautious use of the FiPS.