|Over the past few years, debates among economists on the magnitude of fiscal expansion effects on the economy have seen something of a resurgence in the economics literature. On the one hand, New Keynesian researchers find positive economic effects of expansionary fiscal policy. On the other hand, authors holding a Neoclassical perspective argue that fiscal expansion has very limited or even negative effects on economic activity. In an attempt to reconcile these two perspectives, some economists suggest that the size of fiscal multipliers are highly state-dependent: that is, fiscal multiplier effects vary depending on the overall state of the economy in which expansionary spending was introduced.
Given such ambiguous results, this research pivots to questions around the different kinds transmissions through which fiscal expansion may impact economic activity in the U.S. Our research, first, focuses on the measurement of consumer sentiment effects on the private sector in light of expansionary fiscal policies. Secondly, we study the relation between fiscal deficits and the U.S. current account balance by attempting to shed new light on the topic in the context of consumer sentiment. We note a phenomenon of “Twin Divergences" rather than the often discussed “Twin Deficits". Thirdly, we attempt to reveal how different categories of government expenditures may be a differentiating factor of fiscal expansion effects on private activity; we illustrate this by imposing a control for the most recent 2007-2009 economic recession.
With the application of recursive conventional VAR and Expectational VAR (EVAR) models, we find, firstly, very limited stimulating effects of fiscal expansion on the private sector due to a pessimistic sentiment response to government spending shocks. In addition, within a floating exchange rate regime, the current account balance of the U.S. tends to improve in response to expansionary government deficits, which reveals a phenomenon of “Twin Divergence”. Finally, different types of government expenditures could differentiate expansionary fiscal effects on key macroeconomic variables, such as consumption, investment, output, and consumer sentiment.