Essays on Economic Policy and Consumer Sentiment

Abstract

To boost aggregate demand and create new jobs for the U.S. economy, the U.S. government enacted the American Recovery and Reinvestment Act (ARRA) during the recent Great Recession, one of the largest fiscal stimulus programs in American history. The sluggish economic recovery from the Great Recession has triggered heated debates over the effectiveness of fiscal policy in stimulating the economy. Some researchers report positive economic effects of fiscal stimulus following New Keynesian approach whereas others argue that fiscal stimulus does not appear to stimulate the economy employing neoclassical models. Besides, another group of scholars proposes nonlinear effects of fiscal stimulus depending on the current state of the economy. Given the divided literature on this issue, the objective of this research is to evaluate the effectiveness of fiscal policy in the U.S. under different monetary and fiscal policy regimes. Using a New Keynesian DSGE model with two distinct policy regimes and structural VAR estimation, the first part of our research shows that fiscal policy has become ineffective due to lack of coordination between monetary and fiscal policy. To account for the changes in the fiscal policy transmission, we propose sentiment as an alternative propagation mechanism. We further provide evidence of the sentiment channel through the lens of the Survey of Professional Forecasters data. The second part of our research is the sequel to the first part, which focuses on whether fiscal policy can improve the labor market conditions by identifying shocks to government employment. In this part, we develop a two-sector NK DSGE model and assess the validity of simulation results via a recursively identified VAR model. Also, we highlight dynamic adjustments of sentiment to explain the changing labor market responses to fiscal shocks employing the SPF data. Consistent with the first part, our results show that fiscal stimulus fails to improve labor market conditions if there is consumer pessimism when fiscal and monetary policies are conflicted with each other. In the third part, we examine how forecasters revise their economic prospects through recovering the forecast errors of real GDP growth, unemployment growth and inflation applying the law of iterated projection from the Survey of Professional Forecasters (SPF) and the Greenbook. We point out the existence of systematic bias in both the private sector and Federal Reserve forecasters’ expectations. Motivated by the first two parts, we conjecture that the persistent forecast bias with changed sign might be closely related to changing fiscal and monetary policy regimes.