Sustainability of a fiscal policy and a current account: a threshold cointegration approach for the G-7 countries

Cifuentes, Julio
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This dissertation investigates the sustainability of the fiscal policies and current accounts of the G-7 countries. Sustainability implies---for example in the case of a fiscal policy---that total revenues and expenditures need to be cointegrated with cointegrating vector [1,-1]. Researchers have been using linear cointegration tools to tests for sustainability.;However, the idea of admitting the possibility of a change in regime in which the fiscal policy or current account was sustainable up until some date t and only after that date an unsustainable situation was introduced or vice versa has been in mind of researchers. The intuition behind this idea is that there are large political and transaction costs to adjust the fiscal policy or the current account back on a sustainable situation whenever disequilibria are present. Thus a "threshold" may exist, so that whenever the imbalance is "large" enough the adjustment is done.;The concept of threshold cointegration, which captures the previous idea of a long-run relationship turning "on" and "off", is discussed. A Monte Carlo study is presented to compare the power of the Engel and Granger, Johansen, Horvath and Watson, the ADF, Enders and Granger, and Berben and van Dijk cointegration tests when the true cointegrating error process follows a three-regime TAR. The results of the Monte Carlo study suggest that there is not a test that outperforms the others in all considered situations, and thus a set of tests has to be considered and base the decision on the consensus of the different tests.;After reviewing the econometric tools available, those tools are applied to the sustainability problem for the G-7 countries. It was found an unsustainable Italian fiscal policy. For Canada, France, Japan, the U.K., and the U.S. sustainable fiscal policies were found. Furthermore, evidence in favor of a non-linear behavior, and thus a costly adjustment, is found. On the other hand, the German current account was identified as not sustainable; meanwhile the other 6 countries present a sustainable current account. For the countries with sustainable current accounts no evidence in favor of a non-linear behavior was found.