QUEST II. A Multi-Country Business Cycle and Growth Model

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How fiscal policy affects an economy depends on a wide range of other factors. Assumptions
on financing, the composition of (changes in) expenditure and taxation, as well as the
monetary stance are all crucial elements in the analysis of fiscal policy. The model
distinguishes between various expenditure components and changes in each of these will
have a different impact on the economy. Moreover, for the government’s intertemporal
budget constraint to hold, any increase in spending will have to be accompanied by (future)
increases in taxation and the net effect of a fiscal expansion will depend crucially on which
type of tax is raised.

In the simulations below we look at increases in government purchases of goods and services.
The size of the first shock we consider is equivalent to 1 per cent of real baseline GDP for a
period of 10 years, and then reduced gradually. As discussed above, the model contains a
fiscal closure rule that stabilises the debt to GDP ratio and rules out unstable debt dynamics.
This reaction function adjusts government transfer payments to households to respond to a
deviation of the debt to GDP ratio from its target level. As an increase in government
spending raises government debt, it will lead to a reduction in such transfers to households,
reducing consumption and reversing the increase in the deficit to GDP ratio. Because the
purpose of this standard simulation is to show the direct effects of a fiscal expansion, this
reaction function has been turned off during the first 10 years of the simulation and only
comes into effect after that period. As the simulations reported below were run for 60
additional years after the 10 years shown in the tables, this allows for sufficient time for the
debt to GDP ratio to stabilise in the long run. Of course, the forward looking behaviour of
households is not affected by this change and consumers will still anticipate the future
reductions in transfer payments that are required to stabilise the debt to GDP ratio in the long
run.

While in the long term the effect of a fiscal expansion is negligible, or even slightly negative,
depending on the financing assumptions, the size of the effects in the short run depends
crucially on the conduct of monetary policy. Under a non-accommodating stance of strict
monetary targeting, even the short run output effects of a fiscal expansion are minor, but if
the authorities target nominal interest rates the short run effects can be significant⁸. The latter
in fact implies that following a fiscal expansion, the monetary authorities will allow the
money supply to expand in order to avoid changes in interest rates. It is this accommodating
monetary policy that gives rise to the positive output effects in the initial years of the
simulations.

In the first scenario below we assume an extremely loose form of money targeting in which
German interest rates are kept almost constant in the short run. Moreover, it is assumed that
all European bilateral exchange rates are fixed and in that respect the simulation could be
seen as a variant of an EMS type exchange rate regime with German hegemony and in which
all EU member states participate. The tables in the annex show the macroeconomic effects
for each country. For all countries the impact multiplier is significantly smaller than 1. The
positive output effects of the fiscal expansion do not last long and tend to be reversed in the
medium term. The increase in government purchases reduces private consumption as
households anticipate future reductions in income due to lower transfer payments. Although
the impact of the fiscal impulse on investment is positive, in the medium term investment is
reduced as firms anticipate lower long term profitability. Prices rise as capacity utilisation
increases and real wage costs increase initially. The real effective exchange rate appreciates,

⁸ See Roeger and in ’t Veld (1997a) for an illustration of this on a two country version of the QUEST
model

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