Fiscal policy shocks – such as changes in local government spending or taxes – are a modest but statistically significant source of price differentials within monetary unions like the eurozone or the United States. That is the central finding of new research by Fabio Canova and Evi Pappa, which empirically studies the relationship between fiscal disturbances and regional price differentials in monetary unions using a sample of 9 European countries and 47 US states.
Their results, which are published in the April 2007 Economic Journal, have important policy implications:
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First, since local fiscal policy has a statistically large effect in some states (countries), policy-makers who care about regional price differentials may find an empirical justification for imposing limits to both the size and variability of local fiscal policy.
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Second, balanced budget shocks have large effects on both local output and local prices. Hence, these results also warn policy-makers against imposing too strict fiscal constraints, which, to be maintained, may require dramatic adjustments in the local economy.
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Third, different fiscal instruments have different effects in the local economy. Deficit-financed expenditure shocks produce lagged but more persistent and revenue shocks larger price differential responses. Hence, keeping tax smoothing motives aside, revenue cuts appear to be an important stabilisation instrument while expenditure changes could end up having undesirable pro-cyclical effects. In addition, since surprise declines in local income taxes exercise an important effect on the aggregate supply of the local economy, they may provide a useful channel for stabilising overheated economies.
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Fourth, while there are similarities between the United States and the eurozone, there are also important quantitative differences. It is not possible to tell whether they are due to transitional dynamics, small samples or institutional differences, given the short experience of the eurozone.
The presence of fiscal rules – such as the Gramm-Rudman-Hollings amendment in the United States and the Stability and Growth Pact in the eurozone – signals the aversion of political leaders to regional dispersions. An example of such dispersions is regional price differentials.
Economic theory suggests differentials in productivity and demand factors as possible causes for regional price differentials. While productivity differentials may be innocuous, demand factors, such as government expenditure shocks, are not.
If local government expenditure is an important source of price differentials and if price differentials pose a threat to union-wide inflation stability, central banks may want to monitor closely the dynamics of regional fiscal variables and federal authorities that
dislike regional differences may be justified in attempting to control regional fiscal policies.
Given the short life of the eurozone, the US experience provides valuable information on how price differentials may evolve in response to unexpected variations in fiscal variables. The researchers identify shocks using sign restrictions on the dynamics of expenditures, revenues, deficits and output and construct two estimates for structural price differentials dynamics, one for the average and one for each unit, which optimally weight information contained in the data for all units.
They identify two types of expenditure shocks: those financed by bond creation and those financed by distorting taxation. For revenue shocks, they concentrate on shocks, which increase deficits and output.
The results suggest that fiscal policy is a modest but statistically significant source of price differentials. The magnitude of the effects varies with the unit and the type of shocks but, on average, fiscal disturbances explain 14-23% of price differential fluctuations in both unions.
Heterogeneities however do exist and there are states (countries) where more than 40% of the price differential variability is attributable to some fiscal shock. Interestingly, in Ireland and Germany, two countries under EU scrutiny over the period because of their loose fiscal policy, the variability explained by fiscal shocks is negligible.
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Notes for editors: ‘Price Differentials in Monetary Unions: The Role of Fiscal Shocks’ by Fabio Canova and Evi Pappa is published in the April 2007 issue of the Economic Journal.
Fabio Canova is at the Universitat Pompeu Fabra. Evi Pappa is at the Universitat Autonoma de Barcelona.
For further information: contact Romesh Vaitilingam on 07768-661095 (email: romesh@compuserve.com); or Evi Pappa via email: evi.pappa@uab.es