Fiscal Policy, Productivity and External Adjustment: a Comparative Study

In their research study “Fiscal Policy, Productivity and External Adjustment: a Comparative Study”, the authors, Hafedh Bouakez, Foued Chihi and Michel Normandin evaluate the effects of unexpected tax cuts and increases in public spending on output, labour productivity, the current account and the real exchange rates in four industrialized countries, namely, Canada, the United States, Australia and the United Kingdom.

No existing work attempted to measure the effects of fiscal policy shocks on labour productivity, and the handful of studies that attempted to measure countries’ external adjustment following these shocks mostly focused on US data.

In addition to considering a larger set of countries, the authors use a novel empirical methodology that relaxes the commonly used identifying assumptions, and instead achieves identification by exploiting the time-varying conditional variances of the structural shocks within a structural vector auto-regression (SVAR).

Notwithstanding that the effects of a fiscal policy are not always consistent across the four countries, the authors notice similarities between Canada and the US on the one hand and Australia and the UK on the other hand.

It is found that unexpected tax cuts are expansionary in Canada and the US, but have essentially no effect on aggregate output per capita in Australia and the UK. The increase in output per capita in Canada and the US reflects both productivity gains and higher employment rates.

In response to an unanticipated increase in public spending, output per capita does not respond in a statistically significant manner in Canada, whereas it increases in the three remaining countries. While in Australia and the UK, the increase in government spending triggers an increase in both labour productivity and the employment rate, only the former rises significantly in the US, accounting almost exclusively for the observed increase in output.

The study also reveals that, in general, the primary budget deficit and the current account do not move in tandem in response to fiscal-policy shocks, thus providing little support for the twin-deficit hypothesis.

Finally, the results indicate that unexpected increases in public spending depreciate the currency in real terms in all countries except Canada. This puzzling depreciation from the perspective of standard open-economy models has also been documented by other studies, but those studies significantly understate the magnitude of the exchange rate response, and therefore, the severity of the puzzle.