Analyzing Fiscal Policy and Growth with a Calibrated Macro Model

CEE countries experience a catching up period in economic growth while preparing for accession to the European Union. In several countries we experience an expenditure boom arising either from exuberant expectations of consumers towards EU or EM or a fiscal deficit usually underpinned by an argument that a reallocation of total consumption at the expense of the future is a result of intertemporal optimization. The paper analyses whether this argument is justifiable. The key factors that influence the intertemporal trade-off are country risk and externalities from foreign direct investments. High indebtedness increases macroeconomic risk and discourages investments. If investment externalities exist the investment gap may cause high output loss. With careful calibration of the parameters determining the risk premium and the external effects of FDI the model predicts a 20% annual return of fiscal austerity at the macro level. This number is too high to be justifiable by any reasonable rate of time preference.