Fiscal policy effectiveness and its redistributive consequences: a theoretical and empirical exploration

This thesis contributes to three important topics on the conduct of fiscal policy. First, although the positive effects of fiscal policy on the aggregate economy are often discussed, the literature frequently omits a normative analysis and, moreover, fails to consider political frictions to policy: something frequently observed in fiscal policy debates. This thesis attempts to address these omissions through constructing New Keynesian `dynamic stochastic general equilibrium' (DSGE) models with heterogeneous agents. Exogenous shocks are shown to impact households differently and in polarizing ways, and the results imply that there is a normative justification for countercyclical fiscal policy, but on redistributive rather than aggregate grounds; austerity is observed to have the biggest impact on those agents who do not engage in capital markets, unless targeted on raising production taxes. Second, DSGE models frequently fail to replicate the empirical regularity that private consumption crowds in fiscal stimuli. This thesis overcomes this anomaly through combining the assumptions of external habit persistence and credit-constrained households, both of which are frequently used in the literature, but often in isolation of one another. External habit persistence creates an interaction between the heterogeneous agents whereby the consumption of one impacts the future preferences of others, and in so doing, introduces herding behaviour into an otherwise standard DSGE model. Finally, there is widespread evidence that procyclical fiscal policies have been prevalent in developing countries and often in some industrial nations. It is therefore surprising that, in contrast to the wealth of studies on the sources of such policy, potential consequences have been largely ignored in the existing literature. This thesis empirically estimates that fiscally procyclical countries have lower rates of economic growth and higher rates of output volatility and inflation.