Essays on the macroeconomic effects of fiscal policy

This dissertation broadly examines the macroeconomic effects of fiscal policy. Specifically, it accounts for some key features in the economy that have often been ignored in traditional policy analysis. The first chapter examines the government spending multiplier in the presence of the informal sector. In this chapter, I develop a novel framework that features properties of the informal sector and openness. I then show that, jointly, these two factors account for the documented differences in the size of the government spending multiplier between small open economies and larger economies. In particular, I demonstrate that small open economies generate smaller multipliers due to their larger shares of the informal sector, regardless of the degree of openness. In addition, I show that, contrary to the popular notion in the literature, the multiplier is not always larger in a liquidity trap period than in normal times, particularly when we allow for distortionary taxation. The differences between these two multipliers diminish when the rise in government spending is also accompanied by a cut in the tax rate, as is likely to happen during a recession. When the cut in the tax rate is significantly large, the resultant multiplier is smaller for a liquidity trap period than for normal times, and the likelihood of this happening is higher when we account for the informal sector.

In the second chapter, I account for heterogeneity in the composition of households in terms of the number of savers relative to non-savers, otherwise referred to as “Hand-to-Mouth” (HTM) consumers. I then analyze variations in the optimal tax structure for varying shares of each category of households. Specifically, I compare optimal allocations of taxes in an economy dominated by saver households, each of whom accumulate capital, to one dominated by HTM households who consume all their assets in any given period. I also compare the welfare effects of expansionary fiscal policy in these two economies. I find that, it is welfare optimizing to set taxes lower in the economy dominated by HTM households in the long run compared to the one dominated by saver households. This design allows for more flexibility in adjusting taxes in the short run following a fiscal expansion. The findings also favor a tax structure that puts more weight on consumption taxes relative to income taxes, especially when the economy is dominated by saver households. In addition, fiscal expansion, while welfare improving in the economy dominated by HTM households, is welfare detrimental otherwise due to the varying responses of aggregate consumption to changes in government spending in each economy.

In the third and final chapter, I look at the macroeconomic effects of three alternative debt-sensitive fiscal policy rules in the context of a small open economy, with some features credited to Gali and Monacelli (2005). The first rule (DgY) targets the sovereign debt-to-GDP ratio, the second rule (DY) responds to total debt-to-GDP ratio, whereas the third rule (GY) targets government spending-to-GDP ratio. These rules are evaluated in the light of a debt-neutral benchmark regime under which government spending evolves stochastically. The results provide strong support for the debt-sensitive rules over the debt-neutral regime in terms of stability in output and inflation. But, strengths of each debt-sensitive rule depends on which side of the economy experiences fluctuations; the demand side or the supply side. Following an exchange rate shock, there exists a direct relationship between volatility in the total debt-to-GDP ratio and volatility in output. Therefore, the DY rule, which targets this ratio, is the most successful in lowering volatilities in output. And, as a derivative outcome, it also minimizes fluctuations in domestic inflation. In the case of a cost-push shock however, the established trade-off between volatility in inflation and volatility in output weakens the DY rule as a stabilizing tool, since it also renders both domestic inflation and CPI inflation very volatile. Under this circumstance, the GY rule becomes very appealing as a policy tool, especially if stability in inflation takes priority over stability in output.