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WO R K I N G PA P E R S E R I E SN O 1 3 6 1 / J U LY IDENTIFYING THEEFFECTS OFGOVERNMENTSPENDING SHOCKSWITH AND WITHOUTEXPECTED REVERSALAN APPROACH BASEDON U.S. REAL-TIMEDATAby Jacopo Cimadomo,Sebastian Hauptmeierand Sergio Sola

WO R K I N G PA P E R S E R I E SN O 13 61 / J U LY IDENTIFYING THE EFFECTSOF GOVERNMENT SPENDINGSHOCKS WITH AND WITHOUTEXPECTED REVERSALAN APPROACH BASEDON U.S. REAL-TIME DATA 1by Jacopo Cimadomo 2, Sebastian Hauptmeier 2and Sergio Sola 3NOTE: This Working Paper should not be reported as representingthe views of the European Central Bank (ECB).The views expressed are those of the authorsand do not necessarily reflect those of the ECB.In all ECBpublicationsfeature a motiftaken fromthe 100 banknote.This paper can be downloaded without charge or from the Social ScienceResearch Network electronic library at id 1878979.1 We would like to thank the participants to an ECB seminar, to the International Conference on Macroeconomic Analysis and International Financeand to the North American Summer Meeting of the Econometric Society, for useful comments and discussions. In particular, we would like tothank Gianni Amisano, Agnès Bénassy-Quéré, Stephan Fahr, Davide Furceri, Massimo Giuliodori, Michele Lenza, Philipp Rother, Ad van Rietand Charles Wyplosz. Sergio Sola gratefully acknowledges the Fiscal Policies Division of the ECB for its hospitality. The opinions expressedherein are those of the authors and do not necessarily reflect those of the ECB or the Eurosystem.2 European Central Bank, Directorate General Economics, Fiscal Policies Division, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany;e-mails: and Graduate Institute of International Studies, Department of Economics, 11A Avenue de La Paix, 1201 Genève, Switzerland;e-mail:

European Central Bank, AddressKaiserstrasse 2960311 Frankfurt am Main, GermanyPostal addressPostfach 16 03 1960066 Frankfurt am Main, GermanyTelephone.Any reproduction, publication andreprint in the form of a differentpublication, whether printed or producedelectronically, in whole or in part, ispermitted only with the explicit writtenauthorisation of the ECB or the authors.Information on all of the papers publishedin the ECB Working Paper Series can befound on the ECB’s. ISSN 1725-2806 (online)

CONTENTSAbstract4Non-technical summary51 Introduction62 Related literature83 Empirical strategy3.1 The Ramey defense news shocks3.2 Identifying shocks with and withoutexpected reversal3.3 VAR analysis10114 Results175 Robustness checks5.1 Additional variables5.2 Alternative identification approach236 es321215ECBWorking Paper Series No 1361July3

AbstractThis paper investigates how expectations about future government spending affect thetransmission of fiscal policy shocks. We study the effects of two different types ofgovernment spending shocks in the United States: (i) spending shocks that areaccompanied by an expected reversal of public spending growth below trend; (ii) spendingshocks that are accompanied by expectations of future spending growth above trend. Weuse the Ramey ’s time series of military build-ups to measure exogenous spendingshocks, and deviations of forecasts of public spending with respect to past trends,evaluated in real-time, to distinguish shocks into these two categories. Based on astructural VAR analysis, our results suggest that shocks associated with an expectedspending reversal exert expansionary effects on the economy and accelerate the correctionof the initial increase in public debt. Shocks associated with expected spending growthabove trend, instead, are characterized by a contraction in aggregate demand and a morepersistent increase in public debt. The main channel of transmission seems to run throughagents’ perception of the future macroeconomic environment.JEL: E62, E65, H20.Keywords: Government spending shocks, Survey of Professional Forecasters, Real-timedata, Spending reversal, Fiscal multipliers.4ECBWorking Paper Series No 1361July

Non-Technical SummaryThis paper proposes a new approach to study the effects of government spendingshocks. In particular, we investigate whether expectations about future governmentspending growth are relevant for explaining the impact of fiscal policy shocks onoutput and public debt at the time of the fiscal expansion.Focusing on the United States and on a quarterly dataset spanning the period 1981Q32008Q3, our empirical analysis consists of three steps. First, we collect the fiscalshocks on military expenditure (i.e. the so-called “defense news” shocks) estimatedand reported by Ramey . Second, we propose a new identification procedurewhich combines the Ramey shocks with private sector forecasts of future governmentspending as well as with past spending trends available “in real time”, when the shockoccurred. Based on these data, we are able to divide the Ramey shocks into twocategories: (1) a category including shocks associated with private sector expectationsof a future reversal in government expenditures; (2) a category including shocks thatare not associated with such reversal. Third, we incorporate these two types of shocksin a structural VAR model and we estimate the different response of the economy – inparticular as regards GDP, private consumption and investment, and public debt – tothe two shocks.Our results suggest that expectations indeed matter for the today’s effects of fiscalpolicy shocks and the evolution of public debt. We find that fiscal shocks that arefollowed by an expected future reversal in spending have a positive effect on output,private consumption, and investment. In addition, they are associated with an increasein public debt for about one year. After that, public debt declines, following theautomatic reaction of the budget balance to the economic expansion induced by thefiscal shock. At the same time, it emerges that fiscal shocks characterized byexpectations of further increases of public spending are associated with a reduction ineconomic activity (especially in the short-run) and with a more persistent increase inpublic debt. The latter tends to remain above its initial level over the wholeconsidered horizon. These effects seem to run mostly through the reaction ofconsumers’ confidence about the future macroeconomic environment, which is alsoreflected in a flatter slope of the yield curve in the case of shocks with reversal.ECBWorking Paper Series No 1361July5

1. IntroductionThe global financial and economic crisis of has induced governments inmost industrialized countries to make extensive use of discretionary, in particularspending-based, fiscal policy measures to counteract the economic downturn. While thesemeasures are argued to have averted an even more severe economic contraction,uncertainties regarding the macroeconomic effects of discretionary fiscal policies remain.At the same time, the adoption of fiscal stimulus packages, together with the automaticreaction of government deficits to the economic slowdown, has certainly contributed to thestrong increase in public debt-to-GDP ratios in most countries. These developments havemotivated a lively debate among academics and policy makers on the effectiveness offiscal policies in stimulating economic activity (i.e. on the sign and the size of fiscal policymultipliers), and on the costs of expansionary fiscal policies in terms of public debtaccumulation and risks to the long-term sustainability of public finances.The theoretical literature suggests that fiscal policy multipliers depend on a wide range offactors such as the monetary policy stance, the exchange rate regime, the degree of capitalmarkets integration and credit market frictions as well as agents’ expectations about thefuture path of fiscal policy. The latter were already contemplated by early Real BusinessCycle models (see e.g. Baxter and King, 1993) according to which fiscal expansions canproduce a negative response in private consumption given that they are expected toincrease the future tax burden. Only recently, some studies use (calibrated) NewKeynesian DGSE models to address explicitly the interplay between fiscal policy andmanagement of expectations as a key factor to understand the transmission mechanisms offiscal policy. In particular, Davig and Leeper show that the effects of fiscal policyshocks depend on the future path of monetary and fiscal policy and on the interactionbetween them. Corsetti et al. highlight that the size of multipliers depends onwhether the government will offset the shock with higher future taxes or rather with lowerfuture spending. They find that government spending multipliers are considerably largerwhen fiscal shocks are accompanied by a future reduction in spending. By granting acentral role to the future paths of fiscal policy variables, these papers represent a big stepforward in the understanding of the size and the sign of fiscal policy multipliers.Against this background, the goal of this paper is to test empirically the predictions of thisclass of models based on a new approach that explicitly takes into consideration – in anotherwise standard VAR model for fiscal policy analysis – agents’ expectations about the6ECBWorking Paper Series No 1361July

future fiscal policy stance after a fiscal policy shock. In particular, we investigate whetherexpectations about future government spending growth are relevant for explaining theeffectiveness of fiscal policy shocks and the evolution of public debt following fiscalexpansions.Focusing on the United States and on a quarterly dataset spanning the period 1981Q32008Q3, our empirical strategy consists of three steps. First, we collect the fiscal shocks onmilitary expenditure (i.e. the so-called “defense news” shocks) estimated and reported byRamey . These shocks, constructed following a “narrative” approach, canreasonably be considered to be truly “exogenous” and “unsystematic” and therefore shouldbe immune to the ‘Fiscal Foresight’ Critique (see Leeper, Walker and Yang).Second, we propose a new identification procedure which combines the Ramey shockswith information on forecasts of future government spending as well as on past spendingtrends available “in real time” when the shock occurred. As a proxy for agents’expectations about future government spending growth, we use projections on governmentconsumption and investment spending reported in the Survey of Professional Forecastersand published by the Federal Reserve Bank of Philadelphia. Trends for past spendinggrowth and for the same spending aggregate are constructed from past vintages of realtime data also from the Philadelphia Fed database. Based on these data, we are able todivide the Ramey shocks into two categories, i.e. one including shocks associated withexpectations of a future reversal in government expenditures and the other includingshocks that are not associated with such reversal. More specifically, we define: (i)spending shocks with an expected reversal as those positive shocks for which, at the timethey occur, expected spending growth at the one-year-ahead horizon is below a long-runhistorical trend for spending growth; (ii) spending shocks with no expected reversal asthose positive shocks for which spending growth expected for the next year is above pastspending growth, over the same long-run period.1Third, we incorporate these two types ofshocks in a structural VAR model, including also GDP, private consumption andinvestment, and public debt among other variables, to investigate the differences in theresponses of the economy.To the best of our knowledge, this is the first paper that considers agents’ expectationsabout future government spending, in combination with past vintages of real-time data, to1As discussed below, the category of spending shocks with expected reversal also includes negative defensenews shocks, accompanied by projections on spending growth below above past trends of spending growth.Moreover, the category of spending shocks without expected reversal also includes negative defense newsshocks, accompanied by projections on spending growth below above past trends of spending growth.ECBWorking Paper Series No 1361July7

analyze the effects of different types of government spending shocks. Compared to VARanalysis proposed by Corsetti et al., our approach allows us to estimate the effectsof government spending shocks that are followed by a reversal in spending growth and ofshocks that are followed by a further increase in spending growth.Our results suggest that expectations indeed matter for the effects of fiscal policy shocksand the evolution of public debt. We find that fiscal shocks that are followed by anexpected reversal in spending have a positive effect on aggregate demand. In addition, theyare associated with an increase in public debt for about one year. After that, public debtdeclines, following the automatic reaction of the budget balance to the economicexpansion induced by the fiscal shock. At the same time, it emerges that fiscal shockscharacterized by expectations of further increases of public spending are associated with areduction in economic activity (especially in the short-run) and with a more persistentincrease in public debt. The latter tends to remain above its initial level over the wholeconsidered horizon. These effects seem to run mostly through the reaction of consumers’confidence about the future macroeconomic environment, which is also reflected in aflatter slope of the yield curve in