Fiscal prudence: It's all in the timing – estimating time-varying fiscal policy reaction functions for core EU countries

Berger, T.; Dubbert, T.; Schoonackers, R.

Abstract

When estimating fiscal policy reaction functions (FRF), the literature has well recognized
the importance of non-linearities. However, there is yet very little attempt to formally test
for the presence and potential sources of a non-linear fiscal responsiveness. In this paper
we address this gap by formally addressing model specification of the FRF in a panel of five
EU countries. Employing a Bayesian stochastic model specification search algorithm, we
provide formal evidence for time-varying fiscal prudence over the last 50 years. The primary
balance responsiveness exhibits smooth but significant variation over time and thus confirms
the necessity of a non-linear model. Moreover, the extended results show that dynamics can
be partially linked to the interest rate growth differential and the level of public debt itself.
However, no clear evidence is found in favor of the fiscal fatigue proposition.

Keywords
Fiscal reaction function; time-varying parameters; state-space models; MCMC; stochastic model specification search