Fiscal information flow and the transmission of policy impulses

Ricco, Giovanni (2015) Fiscal information flow and the transmission of policy impulses. Doctoral thesis, University of London: London Business School.

Abstract

In this Thesis, we study the empirical identification of structural shocks in the presence of fiscal foresight and information frictions. In particular, we argue that econometric approaches that do not account for information frictions and are based on intuitions stemming from models of perfect information rational expectations may fail to correctly identify structural shocks. In the first chapter of the thesis (based on Ellahie and Ricco (2012) - "Government Spending Reloaded: Informational Insufficiency and Heterogeneity in Fiscal VARs", with A. Ellahie), we use a large information Bayesian VAR to approximate the flow of information received by economic agents to investigate the effects of government spending. We document robust evidence that insufficiency of information in conventional models could explain inconsistent results across samples and identifications (Recursive Structural VAR and Expectational VAR). Furthermore, we report heterogeneous effects of government spending components. While aggregate government spending does not appear to produce a strong stimulative effect with output multiplier around 0.7, government investment components have multipliers well above unity. Also, state and local consumption, which captures investment in education and health, elicits a strong response. The second chapter (based on Ricco (2014) - "A New Identification of Fiscal Shocks Based on the Information Flow") studies whether discretionary increases in government spending can stimulate the economy. We answer this question by taking into account both the information flow on fiscal measures and the role played by information frictions. Using a novel set of empirical proxies for fiscal news and agents' misperceptions, our approach identifies three types of innovations to government spending that modify the agents' information set at different horizons: before, upon and after the actual change materialises. Borrowing from the psychological literature, we name them expected, unexpected and mis-expected fiscal changes. By missing this important distinction, we show that standard identification strategies blend unexpected and mis-expected changes in a way that leads to significant underestimation of the effects of fiscal policy. An application to US data reveals that once information rigidities are fully accounted for, expected fiscal changes stimulate economic activity and private investments with a cumulative output multiplier around 1.5. In the third chapter (based on Ricco et al. (2014) - "Signals from the Government: Policy Disagreement and the Transmission of Fiscal Shocks", with G. Callegari and J. Cimadomo), we investigate the influence of fiscal policy communication on the propagation of government spending shocks. We propose a new index to measure the coordination effects of policy communication on private agent expectations. This index relies on the disagreement amongst US professional forecasters about future government spending. The underlying intuition is that a clear fiscal policy communication can coalesce agents' expectations, reducing disagreement. Results indicate that, in times of low disagreement about future policies, the output response to fiscal spending announcements is large and positive. Conversely, periods of elevated disagreement are characterised by muted responses. The stronger effects of fiscal policy when expectations are coordinated are due to the accelerator effect of planned fiscal spending on private investment.