Contemporary Economic Issues and Analysis:

Second Part - Lecture 1

Fiscal Policy

Ruhollah Eskandari - Omid

r.eskandari@york.ac.uk

Office: A/EC/108
Office Hours: Friday 10-12

Feel free to drop by or send me an email if you’re interested in

scheduling a Zoom meeting.

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Structure of the Module and Exam

Structure
The first half of the module is delivered by Professor Emma Tominey,
focusing on Microeconomics and covers four topics
The second half of the module is delivered by Dr. Omid Eskandari,
focusing on Macroeconomics and covers four topics
Exam
A closed-book written three-hour examination
The exam will consist of two parts: Part A (Emma’s section) and Part
B (Omid’s section)
Each part contains two questions, with each question worth 25 marks
You must answer all four questions in the exam
The exam is not essay-based, but there are no word limits
Please look at the past exam paper available on the VLE for details.

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Structure of the Second Half

Topic 1:
An overview of fiscal policy and fiscal austerity (lecture 1)
Analyse an empirical study (practical 1)
Topic 2:
Political economy of budget deficits (lecture 2)
Seminar questions (seminar 1)
Topic 3:
An overview of corporate finance and corporate decision-making under
uncertainty (lectures 3 and 4: one-hour lectures)
Analyse an empirical study (practical 2)
Topic 4:
Tax policy and corporate decisions (lecture 5)
Seminar questions (seminar 2)

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Online Sessions and Guest Lecture

Online Sessions:
Review session: I will record a review session where I will review the
second-half topics, provide a mock exam, and discuss it. I will upload it
on the VLE before Week 11.
Drop-in session: I will run an optional online drop-in session in Week
11, where you can join to ask your questions.

Guest Lecture (not examinable):

On Thursday, 1 May 2025 (Week 10), Professor Michal Horváth,
Executive Director of Monetary Policy at the National Bank of Slovakia
and former Minister of Finance, will deliver an honorary guest lecture.
He will discuss the natural rate of interest and how uncertainty
surrounding this unobservable measure influences policy discussions
It is not examinable but will help you to better understand the second
half macro topics.

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Approach for Each Topic

Theoretical Framework: Brief overview of economic theories and

their predictions
Empirical Evidence: Review of relevant empirical studies testing
these theories: Data & Econometric Analysis
Key Empirical Challenges: Discussion of identification issues, IVs,
endogeneity, measurement issues, and other concerns.

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Thinking Like an Economist!

1 Theoretical Framework
Economics as a social science studies societies and human interactions
Influenced by multiple variables, making analysis complex
Related to disciplines like Psychology, Politics, Geography, and Business
Simplified representations of reality with assumptions to manage
complexity.
2 Empirical Analysis
Use data to validate or challenge theoretical predictions
Apply techniques like regression analysis, Instrumental Variables (IV),
Difference-in-Differences (DiD), ...
Address challenges like endogeneity, omitted variable bias, identification
issues, ...
Policy implications

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 An Overview of Fiscal Policy

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Big Picture: Macroeconomic Policy

1 Demand side policies (short-term stability): attempts to increase

or decrease aggregate demand to affect output, employment, and
inflation.
Fiscal Policy (Government): government spending or tax policy
Monetary policy (Central banks): interest rate or money supply
Expansionary or Contractionary: Expansionary policies (increasing
government spending, cutting taxes, lowering interest rates) are
intended to stimulate spending in a recessionary economy;
contractionary policies do the vice versa.
2 Supply side polices (long-term growth rate): attempts to increase
productivity and increase efficiency in the economy: deregulation; free
trade agreements; improved education and training, improved
infrastructure, etc.

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Big Picture: Macroeconomic Policy

Demand- and supply-side policies

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Basic Concepts of Fiscal Policy

National Income Accounting: Y = C + I + G + NX

Y: Output (GDP)
C: Consumption expenditure, C = α + MPC (Y − T )
I: Investment spending
G: Government purchases
NX: Net exports=Export - Import
α is the autonomous consumption
MPC is the Marginal Propensity to Consume (the change in consumption
divided by the change in disposable income), and MPS is the Marginal
Propensity to Save. 0 < MPC < 1 and MPC + MPS = 1
Average MPC in the Euro Area: 0.46; Netherlands: 0.33; Greece: 0.57;
Italy: 0.48. Source here
MPC in the United Kingdom: Professional Households: 0.47; Skilled
Households: 0.93; Unskilled Households: 0.65; Unoccupied Households:
0.80. Source here
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Demand side policies - a schematic representation: IS/LM Model

IS/LM Model (closed economy)

IS relation: Y = C (Y − T ) + I(Y , i) + G = f (T , G, i)
LM relation: M/P = f (Y , i)

Goods and Money Market Equilibrium

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Fiscal Multipliers: Definition

Fiscal Multiplier: ratio of a change in output to a discretionary

change (exogenous change) in government spending (∆Y /∆G) or
tax revenue (∆Y /∆T ).
Fiscal multiplier measures the effect of a £1M change in spending or
a £1M change in tax revenue on the level of GDP.

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What do we know about the size of fiscal multipliers?

1. Macroeconomic Theory:

From the perspective of macroeconomic theory: since

0 < MPC < 1 and 0 < MPS < 1, then tax multiplier is smaller in
absolute value compared to the government spending multiplier.

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Mechanism?

When the government increases its spending (∆G=£1M), it directly

boosts aggregate demand (∆Y =£1M). This initial injection can lead
to a multiplied effect on the economy based on MPC , as the
recipients of the spending (e.g., contractors, employees) spend their
additional income, further stimulating demand.
Conversely, reducing taxes (∆T =-£1M) first boosts individuals’
disposable income, but only a portion of it is spent to increase
aggregate demand (∆Y = ∆C = MPC ∗ ∆T ). The rest is saved.
Therefore, the impact on aggregate demand from a change in
government spending is typically greater than that resulting from a
change in taxes.
Galı́, J., López-Salido, J.D. and Vallés, J., 2007. ”Understanding the
effects of government spending on consumption.”, Journal of the
european economic association, 5(1), pp.227-270.

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Empirical Findings

2. Empirical Findings:
Ramey, Valerie A. ”Ten years after the financial crisis: What have we
learned from the renaissance in fiscal research?.” Journal of Economic
Perspectives 33, no. 2 (2019): 89-114.
This paper is an essential reading for this topic.
Government spending multipliers: Generally positive but fairly narrow
range between 0.6 and 1 (1), meaning government spending boosts
GDP but may crowd out private activity.
Tax multipliers: vary significantly across methods, between -2 and -3,
indicating tax cuts strongly boost GDP.

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Figure 1 shows the estimated impulse responses of the log of the government spending
variable and the log of the GDP variable.
Because the variables are in log form, the impulse responses show elasticities, not the
dollar changes required by multipliers, so multipliers cannot be read directly from the
graphs.
Confidence intervals (shaded areas) in IRFs help assess whether a shock has a statistically
significant effect over time.
If the confidence interval includes zero at a given horizon, it suggests that the response
may not be statistically significant at that time point.
Confidence Intervals in IRFs are conceptually similar to confidence intervals in regression
analysis, but they extend over time rather than being associated with a single coefficient
estimate.
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Summary

1 From the perspective of macroeconomic theory: the multiplier for

government spending is typically larger than that for taxes.
2 The empirically literature gives a different message, suggesting that
tax multipliers are larger than spending multipliers.

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Empirical challenges

Endogeneity - Identifying exogenous fiscal shocks is difficult because

changes in fiscal policy often respond to economic conditions.
Anticipation - Many fiscal policy changes are anticipated in advance,
meaning their effects may already be priced into economic behavior
before implementation.
Nonlinearity - Fiscal multipliers depend on various factors such as:
Persistence of the policy: whether temporary or permanent
Type of spending: military spending; R&D; education; infrastructure
projects, ...
Financing methods: borrowing; tax-financed; monetisation
Monetary policy reactions: accommodative monetary policy (low
interest rates) or monetary policy offsetting fiscal stimulus (interest
rate hikes)
State of the economy: recessions vs. expansions & high vs. low
uncertainty

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Endogeneity: Fiscal Rule vs. Fiscal Policy

Fiscal Rule: Automatic Stabilizers:

Automatic Stabilizers (predetermined rules): Automatic stabilizers,
without specific new legislation, increase (decrease) budget deficits
during times of recessions (booms). Examples include: Corporate
Profits, Progressive Income Taxes, The Unemployment Insurance (UI)
Program.
When the economy begins to go through an economic fluctuation,
automatic stabilizers immediately respond without any official or
government body having to take action.

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Fiscal Rule: Automatic Stabilizers

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Fiscal Policy

Discretionary policies refer to actions taken in response to changes in

the economy, but they do not follow a strict set of rules; rather, they
use subjective judgment to treat each situation in unique manner.
Discretionary fiscal policy is made more difficult due to lags in
recognizing the need for changed fiscal policy and the lags that occur
with enacting the changed fiscal policy. Implementing the modified
fiscal policy usually requires legislative action, which takes a long time
to implement. There is a concern that fiscal policy changes may be
ill-timed, however.
Discretionary policies:
1 Endogenous: response to other factors affecting output in the short or
medium run
2 Exogenous: use to measure multipliers

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Identifying Exogenous Shocks: Solutions for Endogeneity

1 Statistical models: Structural Vector Autoregression (SVAR) Models

2 Adopts a narrative approach to identify observable exogenous shifts of
the policy by analyzing historical documents, legislative records, or
policymakers’ statements. Instead of relying solely on statistical
models, this approach uses qualitative sources to determine whether a
policy change was motivated by economic conditions or by other
factors, such as ideology or long-term policy goals.
3 Natural experiment methods use unexpected or externally driven
changes in policy to study causal effects, similar to a controlled
experiment but without deliberate intervention.

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Identifying Exogenous Shocks: Narrative Approach

Identifying Exogenous Tax Shocks:

Romer and Romer (2010) pioneered the narrative approach in fiscal policy
research by analyzing historical records to identify exogenous tax
changes—those unrelated to current economic conditions.
1 Tax cuts taken to achieve a long-run goal:

Ronald Reagan cut taxes in the early 1980s, because he believed lower
tax rates were good for long-term growth
Donald Trump cut corporate taxes (40% reduction) in the U.S. in 2018
because he believed that lowering corporate tax rates would boost
economic growth, attract investment, create jobs, and ultimately help
”Make America Great Again.”
2 Tax increases taken to deal with an inherited budget deficit:
Bill Clinton raised taxes in 1993, because he believed dealing with the
deficit would be good for the long-term health of the economy.
Romer and Romer (2010) , Eskandari and Zamanian (2023)

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Identifying Exogenous Shocks: Narrative Approach

Identifying Exogenous Government Spending Shocks:

This method, pioneered by Ramey (2011), involves historical analysis of
government decisions to pinpoint exogenous government spending shocks.
Use historical narratives to identify exogenous variations in
government spending, which they then use as instrumental variables
to estimate the effects of government spending shocks on the
economy.
Their approach involves analyzing historical accounts of government
spending decisions and identifying periods where spending changes
were largely driven by exogenous factors such as wars.
For example, if government spending increased because of a war or
defense buildup, it is considered exogenous since it wasn’t influenced
by business cycles or economic downturns.
Ramey (2011), Ramey and Zubairy (2018), Ramey (2016)

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Identifying Exogenous Shocks: Natural Experiment

A natural experiment is a research method that uses unexpected or

externally driven changes in policy to study causal effects, similar to a
controlled experiment but without deliberate intervention. Natural
Disasters (earthquakes, hurricanes, and floods); Political Decisions
Unrelated to the Economy; Pandemics (e.g., COVID-19)
Political Decisions:
Acconcia, Corsetti, and Simonelli (2014) used the Italian central
government’s response to Mafia infiltration as an exogenous (external
and unplanned) variation in government spending across different
provinces. When the government dissolved local councils due to Mafia
influence, it resulted in sudden changes in public investment and
spending in those areas.
Since the Mafia intervention was not related to economic conditions,
this created a quasi-random variation in government spending.
Acconcia et al. (2014)

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Solutions for Anticipation

Traditional fiscal policy studies often assume that tax changes and
government spending affect the economy only when they are
implemented.
However, in reality, tax cuts, spending increases, or fiscal
consolidations are often announced in advance and can affect
economic behavior before they take effect (e.g., firms may delay
investment until a tax cut takes effect).
Mertens & Ravn (2012): Distinguishing Anticipated vs.
Unanticipated Fiscal Shocks.
To correct for this issue, Mertens and Ravn separate fiscal policy
changes into two categories:
1 Unanticipated (Surprise) Fiscal Shocks → Immediate tax changes that
were not expected by agents.
2 Anticipated Fiscal Shocks → Policy changes announced in advance but
implemented later. Mertens & Ravn (2012)

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Anticipated vs. Unanticipated U.S. Tax Policy Shocks

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