Persistent and Heterogeneous Effects of Fiscal Shocks: Hysteresis and Its Mechanisms

Abstract: Discretionary fiscal expansions may do more than smooth cycles: they can durably raise output. Using OECD panel data and a fiscal-rule identification of spending shocks combined with local projections, I find that expansions produce persistent output gains. The persistence is driven by supply-side improvements–capital deepening and higher productivity–with private demand responding without sustained inflation. Effects are state-dependent: they are stronger in recessions, weaker when indebtedness is high or trade openness is very large, and their transmission differs across exchange-rate regimes. Significant non-linearities concerning the size of the shock are also identified. Large expansions generate the durable effects, while small ones mostly smooth the cycle. The results imply that the scale and design of fiscal packages–as well as the macro-financial environment that supports investment and productivity–are pivotal for durable impacts.