73rd International Atlantic Economic Conference

March 28 - 31, 2012 | Istanbul, Turkey

Is fiscal policy more effective during cyclical downturns?

Thursday, 29 March 2012: 9:10 AM
George Karras, PhD , Economics, Univ. of Illinois at Chicago, Chicago, IL
Is Fiscal Policy More Effective During Cyclical Downturns?

 

Georgios Karras*

University of Illinois at Chicago

November 2011

Prepared for the 73rd IAES Conference, 28-31 March 2012

Abstract

This paper asks whether the effectiveness of fiscal policy depends on whether the economy is experiencing a downturn or an expansion, as suggested by various theoretical models that take into account factors such as the slope of the aggregate supply, how close the economy is to the zero lower bound for nominal interest rates, the extent of crowding out, and the degree of liquidity constraints.

The paper uses annual data from the 1952 to 2007 period, for 61 developed and developing economies, which exhibit varying degrees of business-cycle variability.  The empirical findings show that fiscal policy is indeed more effective during downturns than during expansions.  In addition, the difference is quantitatively substantial: the estimated models imply that the short-run and long-run fiscal multiplier is roughly twice as large when output is below trend.  The reason for this difference can be traced to the responses of private consumption and investment, both of which respond more to a given change in government spending during downturns.

More specifically, our findings suggest that during expansions, when output is above its long-term trend, the output “multiplier” is less than one, private consumption is crowded out, and the response of investment is weak.  However, during downturns, when output is below the trend, the output multiplier is greater than one, private consumption is not crowded out, and the response of investment is strong.  Not surprisingly, periods of expansion are more consistent with the theoretical predictions of neoclassical models than are downturns.

JEL classification: E32, E62

Keywords: Fiscal policy, Fiscal multiplier, Business fluctuations



* Professor of Economics, Department of Economics, University of Illinois at Chicago, 601 S. Morgan St., Chicago, IL 60607‑7121; e-mail: gkarras@uic.edu.