The Transmission Mechanism of Fiscal Policy: A Critical Assessment of Current Theories and Empirical Methodologies

This paper reviews the current theoretical and empirical literature on the transmission mechanisms of fscal policy. Its main conclusion is that there is nothing closely approaching an agreement on the effects of fscal policy. The theoretical and empirical literature on the subject is scarce and divisive. The predictions of the neoclassical theory and the new Keynesian theory, as well as the “narrative” or “dummy variable” and the “structural vector autoregression” (SVAR) types of empirical analyses of fscal policy all rest on shaky foundations—namely, the intertemporal government budget constraint, the Ricardian equivalence hypothesis, and severe empirical restrictions in order to identify fscal shocks.