Fiscal Policy, Interest Rates, and Output: Equilibrium-Correction Dynamics in the US Economy

Joint modelling of fiscal and monetary policies should elucidate on their interaction. We estimate a large parsimonious structural vector equilibrium correction model (PSVECM) to analyse the dynamics of eight variables from the US economy. Shocks to fiscal and monetary variables reveal interesting observations, with the results broadly in agreement with economic theory. A shock to only government spending indicates a government spending multiplier of 1.62. There is also a temporary increase in the cost of borrowing. However, a simultaneous shock to both tax and spending that leaves the deficit unchanged suggests a balanced budget multiplier of 1.77. Increasing the federal funds rate by a percentage point is followed by falling output, inflation, and tax revenues but the change in government spending is insignificant. In addition, the yield on thirty-year maturity corporate bonds rises by 0.32 of a percentage point.