Fiscal Space Based State-Dependent Non-Linearities In Output Response To Fiscal Policy Shocks: A Non-Parametric Analysis

"This paper explores non-parametric econometric methods to study the nonlinear effects of fiscal policy shocks on economic activity, contingent upon varying levels of fiscal space availability. The fundamental motivation for non-parametrics is the lack of consensus on the effectiveness of fiscal policy during economic crises due to possible non-linearities in the mechanisms associated with fiscal policy transmission. Traditional VAR methods, most commonly utilized in related literature, are linear parametric approximations, which do not sufficiently capture these nonlinear dynamics of interest whereas nonparametric methods offer a lot of opportunity to experiment with non-linear specifications. This paper explores two main non-parametric impulse response estimation techniques, namely local projections--first popularized in Jordá (2005)-- and Gaussian Mixture Approximation or Functional Approximation of Impulse Responses-- a novel methodology proposed by Barnichon and Matthes (2018). The exploration of these new methods is undergirded by fiscal policy analysis, with a focus on fiscal space based state-dependent non-linear impulse responses of output to fiscal policy shocks. We use non-linear local projections for empirical analysis of the effectiveness of fiscal policy given fiscal space considerations. The results suggest that fiscal policy becomes ineffective in stimulating economic activity in tight fiscal space environments. This can have significant implications for the government’s ability to counter large recessionary contractions when the fiscal space is constrained. "

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