The General Equilibrium Effects of Fiscal Policy: Estimates for the Euro Area

Abstract

This paper describes a dynamic stochastic general equilibrium model featuring a fraction of non-Ricardian agents in order to estimate the effects of fiscal policy in the Euro area. The model takes into account distortionary taxation on labor and capital income and on consumption, while expenditures are broken down into purchases of goods and services, compensation of public employees and transfers to households. A newly computed quarterly data set of fiscal variables is used. Our results point to the prevalence of mild Keynesian effects of public expenditures. In particular, although innovations in fiscal policy variables tend to be rather persistent, government purchases of goods and services and compensations for public employees have small and short-lived expansionary effects on private consumption, while innovations in transfers to households show a slightly more sizeable and lasting effect. The effects are more significant on the revenue side: decreases in labor income and consumption tax rates have sizeable effects on consumption and output, while a reduction in capital income tax favors investment and output in the medium run. Finally our estimates suggest that fiscal policy variables contribute little to the cyclical variability of the main macro variables.