The effects of fiscal policy in a small, open economy : a structural VAR analysis of fiscal shocks in Norway employing sign restrictions

Abstract

This thesis investigates how fiscal policy affects output (GDP) in a small, open economy. The analysis utilizes data on Mainland GDP, government spending and taxes in Norway from 1978 to 2017. In order to identify and estimate effects of exogenous fiscal shocks, we employ the sign restrictions approach in a Structural Vector Autogregression (SVAR) model. Our study represents a solid contribution to the literature of fiscal policy for two main reasons. First, we aim to provide empirical evidence on the effects of fiscal policy shocks in a small, open economy, for which the empirical literature is limited. Second, we conduct such an analysis through employing the sign restrictions approach which has not been widely applied thus far. Therefore, the study of Norway through such an approach provides a novel contribution to the suitability of the sign restrictions approach for small, open economies. We find a positive effect on GDP from an increase in government spending, although the spending multiplier on GDP is weak and insignificant in the short run. Following a tax increase, GDP is negatively affected with a significant effect on impact. However, this negative effect is rather short-lived and becomes positive when including private consumption and investment in the model. Thus, we do not find a conclusive effect from tax shocks through the sign restrictions approach. We argue that the inconclusive findings in our analysis are likely due to a limited amount of identified fiscal shocks when employing sign restrictions. This is further supported when utilizing a more conventional recursive ordering approach for identification, through which we find a significantly positive effect on GDP following spending shocks. However, neither the sign restrictions or the conventional recursive approach provides conclusive evidence for tax shocks. Thus, we find that the analysis of net tax levels is an inadequate measure for tax effects in Norway, as tax changes in Norway predominantly focus on marginal tax rates and taxation structures. Keywords – Fiscal policy, Macroeconomics, VAR, Sign restrictions