Identification of fiscal SVAR-IVs in small open economies

TL;DR

This paper develops a method to identify fiscal shocks in small open economies using forecast errors of trading partners, providing new estimates of fiscal multipliers for Canada and the euro area.

Contribution

It introduces a novel identification strategy for fiscal shocks leveraging forecast errors, applicable to small open economies, and provides empirical estimates of fiscal multipliers.

Findings

Baseline two-year fiscal multiplier for Canada around 1.

Baseline two-year fiscal multiplier for euro area around 0.5.

Instrument is relevant and likely exogenous in the studied contexts.

Abstract

We identify fiscal SVAR-IVs by utilizing unexpected variation in the output of trading partner economies, measured by professional forecast errors, to account for the systematic component of fiscal policy. Our identification builds on the small open economy assumption that these forecast errors correlate with output but are exogenous to domestic fiscal policy. In applying our approach to Canada and euro area small open economies we show that the instrument is relevant and find suggestive evidence for its exogeneity. Our baseline estimates for the two-year cumulative spending multiplier are around 1 for Canada and 0.5 for euro area small open economies.