The Relative Impact of Fiscal versus Monetary Actions on Output: A Vector Autoregressive (VAR) Approach

Dawit Senbet

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Monetary Policy and Economic Impact Fiscal Policies and Political Economy Market Dynamics and Volatility

Abstract

The seminal work of Andersen and Jordan [1] on the relative importance of fiscal and monetary policy for output stabilization (the St. Louis equation) caused many debates among economists for a long period. They run a single equation model testing the relative importance of monetary versus fiscal policy on nominal GNP and concluded that monetary policy is effective and fiscal policy is ineffective on output stabilization. This finding attracted a wide range of criticisms and debates mainly due to possible endogeneity between policies and economic activity, and misspecification of the model. This study takes the St. Louis equation seriously. Our main concern is that, the economic activity is represented by nominal output and to our surprise; the impact of monetary or fiscal policies on prices has not been given any attention. All such models with nominal output as the dependent variable could not address the question of how policy induced changes are split between a change in real output and a change in prices. This paper investigates the relative impact of monetary and fiscal policies on the U.S. real economic activity, using quarterly data between 1959:I and 2010:II. We employ Granger causality tests and Vector Autoregressive (VAR) models. The VAR methodology also helps in resolving the issue of endogeneity between policies and output. The results from both models indicate that monetary policy is relatively better than fiscal policy in affecting the real output. No other study attempted to investigate the relative impact of monetary and fiscal policy actions on real output in the St. Louis framework as well as the econometric approach used in this paper to address the issue.

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References

1980Macroeconomics and Reality 1972MONEY, INCOME, AND CAUSALITY 1989The federal funds rate and the channels of monetary transmission 1992‘Interpreting the macroeconomic time series facts: The effects of monetary policy’1968Monetary and Fiscal Actions: A Test of Their Relative Importance in Economic Stabilization 1972Some Implications of Endogenous Stabilization Policy 2010Stock Market and Economic Growth: An Empirical Analysis for Germany 1978Does the St. Louis Equation Now Believe in Fiscal Policy?

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