Systematic Fiscal Policy and Macroeconomic Performance - Essay Example

Systematic Fiscal Policy and Macroeconomic Performance Systematic Fiscal Policy and Macroeconomic Performance Introduction Economists have always emphasized on the effects of macroeconomic factors on systematic fiscal policy. Systematic policy refers to a fiscal policy that systematically depends on factors such as output a debt among many economic aggregates. Automatic stabilizer is an example of economic aggregate. The events of 1970s and 1980s have led to the shift of emphasis to evaluation of the effects of monetary policy. The situation started changing with the onset of the Great depression as well as introduction of interest rates set as the zero lower bound (Díaz-Roldán et al., 2013). This paper analyzes the significance of empirical literature in the combination with theoretical literature to develop a policy literature. The paper adds to the understanding of the impacts of systematic fiscal rules and fiscal policy according to microeconomic contexts. As a result of various developments there is the need for an appraisal of the current literature. A wide scrutiny of both the empirical and theoretical literature reveals an increased emphasis on the function of transfer payments as well as credit-market constraints as a mechanism for propagation. Though expanding, the small policy literature is noticed to be applying concepts of theoretical literature to the current situation. With the view of theoretical sub-strands, there is a possibility of synthesizing a number of key points (Schmidt, 2013). Fiscal monetary interactions and fiscal policy have been the areas of focus of the early empirical literature, especially for price elasticity. Developing a synthesis from the current state of literature in relation to industrialized countries, there has been a strong stabilization policy which fiscal authorities has functioned to engage. In addition, the stabilization policies which have had a high degree of strength portray countercyclical adjustments to terms such as constant tax rates and transfer payments (Díaz-Roldán et al., 2013). On the other hand, fiscal policies have been involved in consolidating policy basically by the use of purchase and tax adjustments. Despite the fragmentation in empirical literature, particular patterns often emerge. It is evident that theoretical literature has had a wide scope of focus on issues such as optimal fiscal policy, the interrelationship between fiscal multipliers and systematic fiscal policy, the mechanisms of basic fiscal transmission, the role of size of the government, and stabilization policies. There is no proper lining up of theoretical literature with empirical literature except in the role of government size. The increasing emphasis on transfer payments and the rule of thumb consumers is likely to benefit the theoretical literature (Schmidt, 2013). The emphasis on the rule of thumb consumers goes I conjunction with the latest developments in the labor market literature. Due to the evident fragmentation in the general economic literature, a broad scope of analysis can assist in uncovering some similarities which would go unrealized. Such analysis is destined to provide guidance to students, researchers, and readers towards the objective findings from various strands of literature. The analysis is done using two main approaches which are a theoretical strand and an empirical strand. The empirical part includes fiscal monetary interactions and fiscal sustainability from early qualitative literature. Apart from the qualitative literature, the empirical section also covers the quantitative literature that deals with the response of systematic fiscal policy (Díaz-Roldán et al., 2013). Finally, it contains a quantitative analysis on relationship between output volatility and government size. Theoretical part progresses in a fragmented manner. It gives a brief coverage of transmission channels of regarding fiscal policy. It also provides highlights on fiscal stabilization, fiscal monetary interactions, impacts of fiscal monetary interactions, and fiscal stabilization policy. Giving economic approach with the structure helps an individual to identify similarities and differences that exist in the literature and specifically in the theoretical literature (Schmidt, 2013). There is the need to establish a comprehensive analysis that focuses on key elements of literatures. The analyses are necessary in understanding the current economic concept in the globalized world. Quantification of systematic fiscal policy Sustainability testing Previous empirical literature studies on systematic fiscal policy emphasize on the relationship between fiscal sustainability and monetary policy. Many theoretical results have shown that fiscal policy has to be “Ricardian”. Similarly, the findings have established that the government has to act to obey its budget constraints that exist in states around the world. The objective of that is to ensure a proper monetary control of price behavior. The findings motivated researchers to explore much econometric work and developed accurate statistical tests aimed at establishing debt sustainability. Various tests were developed to ascertain if the US public debt has gone through a sustainable course (Díaz-Roldán et al., 2013). The tests also aim at proving if the US has historically followed stationary process in handling debt. In addition they find out if proper co-integration in revenues and spending. In the last few years, emphases have shifted from large VECM systems to parsimonious models on fiscal policy. Rule of thumb fiscal rules were proposed by a study in relation to the previous estimates. In that case, there is automatic engagement of fiscal authorities on stabilization policy. In relation to that, the deficit GDP ratio falls or rises by 0.5% for every one percent change in the output gap. The studies show that modeling of fiscal policy could be done by the use of implicit or explicit type of the rule (Schmidt, 2013). Another finding has established that the level of government expenditure positively relates to output gap when finding a fiscal rule in DSGE model. Second, there is a positive relationship between the level of tax rate and the level of output gap. Third, lagged budget deficits cause government expenditure to fall. Last, lagged deficits cause taxes to rise. Quantification of systematic fiscal policy in areas outside the US A quantitative literature has focused on systematic fiscal policy as it occurs in industrialized other than the United States. Similarly, the literature has experienced various challenges and came up with mixed conclusions. One section of the literature has focused on determining the cyclicality of fiscal aggregates for developed and industrialized countries. A paper was compiled to find the evidence on the relationship between tax revenue and output gap for many countries whereby the specific tax system of each country was used. Studies have used the set of metrics to explain the systematic differences found in the level of stabilization policy in the world. Cyclicality can also be measured by use of regression-based approach similar to that of the US (Díaz-Roldán et al., 2013). According to the approach, political power dispersion has a positive relationship with the pro-cyclicality of different levels of government expenditure. On the other hand, GDP has negative relationship with pro-cyclicality of government expenditure. Quantification of stabilizing effects of government size There is a well-focused literature that discusses the stabilizing impacts/effects on government size apart from that on consolidation and stabilization policies. The literature is based on studies that have documented that, in many countries including the US, high government expenditure in GDP is as a result of low volatility in GDP, private consumption, employment, and private consumption. In as much as the government size associates with low volatility, there is no relationship between consolidation policy and volatility. Further elaborations to the findings establish that high rate of transfer payments or taxes are associates with less volatility (Schmidt, 2013). Regression of volatility is found in by getting output growth associated with government size apart from anti-cyclicality of fiscal policy. In the end the studies assert a negative statistical relationship between output volatility and government size. Standard fiscal policy transmission mechanisms In order to gain a proper understanding of the theoretical rules of fiscal policy, it is important to have the knowledge in transmission mechanisms of fiscal policy. A strong theoretical foundation for familiarizing one’s self states that the financing of fiscal policy takes place through non-destructive taxes , as a result, it is the responsibility of pricing of government debt to ensure that the current fiscal expansion leads to relatively large fiscal contraction in future. The case implies that the economic state of every household should be relatively constant. However, the ideal situation cannot exist. This part suggests three which in which macroeconomic behavior can be affected by fiscal policy. First, there is a variation in government purchases with time. Secondly, the section acknowledges that tax can be distortionary which undergoes a substitution effect operation (Díaz-Roldán et al., 2013). Third, a situation can occur whereby some consumers might be forced to spend transfer payments rather than saving them. Fiscal-monetary interactions in New Keynesian models Fiscal policy can influence the operations of policymakers, which in turn affects stabilization of inflation. Literature on fiscal-monetary interactions has proved that systematic fiscal policy can potentially determine the ability of monetary policy to target price levels. The strand of literature has affirmed that the tendency of central banks to influence price levels is affected by the availability of an appropriate fiscal regime. The foundation of the observations is debt valuation equation. The equation states that the current value of real primary surpluses equals the real value of public debt (Schmidt, 2013). The inability of the systematic conduct of the policy to ensure that debts match surpluses is tested in the policy. Monetary authorities have to work within systems where interest rates do not respond proportionately to inflation. The system is characterized by interest rates, inflation, debt levels, and output. It should be noted that old Keynesian logic does not affect price levels as far as aggregate demand is concerned. Optimal fiscal policy Studies in optimal fiscal policy have established that it is able to create adjustments on distortionary taxes and real purchases in relation to shocks. Scholars have come up with optimal fiscal policy path by the use of linear quadratic approach. The proposed approach is based on RBC model. The results find that labor taxes should be relatively stable and should not fluctuation. The stability is necessary because distortions from labor taxes occur in relatively large and convex dimensions. It is also found that the results are not robust to varied specifications of the wage bargaining process and labor markets. Optimal fiscal wage is tilted towards stabilization by labor wedge (Díaz-Roldán et al., 2013). Recent studies have started considering zero lower bound on nominal interest rates when looking at optimal fiscal policy. It is evident that initial debt level can influence the extent to which fiscal responds. The stabilizing effects of stabilizing policy Rules-based policy has a significant literature. The section has particularly dealt with systematic stabilization policy. Studies of rule-based policy have always emphasized on one fiscal instrument per an analysis. This section explains the impacts of spending-based stabilization, tax-based stabilization policy, and transfer-based stabilization. It is necessary to differentiate between the impacts of progressive tax rates and the impacts of pro-cyclical behavior in marginal tax rates (Schmidt, 2013). Another channel that can be used by tax-based stabilization to operate is that which depends on progressive tax rates. In accordance to real government purchases, this section focuses on stabilizing the impact in case the purchases vary counter-cyclically. Stabilization takes place because pressure on private consumption reduces with the increase in the purchases during bad times. Conclusion The main share of stabilizing policy in most industrialized countries constitutes counter-cyclical transfer payment and pro-cyclical tax revenue. In the countries, most consolidation policy that relates to public debt is accounted by adjustment to taxes and not transfer payments. Less output volatility is associated with large government size. The growing policy literature tends to focus on theoretical literature. The literature of systematic fiscal policy is very instrumental. Empirical has been significant in understanding the relationship between macroeconomic stability and fiscal policy. Theoretical literatures are useful in assisting researchers in understanding the effects of different types of fiscal policy regimes. References Díaz-Roldán, C., & Monteagudo-Cuerva, C. (2013). Fiscal policy under alternative monetary policy regimes. Business & Economic Horizons, 9(2), 1-9. Schmidt, S. (2013). Optimal Monetary and Fiscal Policy with a Zero Bound on Nominal Interest Rates. Journal Of Money, Credit & Banking (Wiley-Blackwell), 45(7), 1335-1350. doi:10.1111/jmcb.12054 Read More