International Transmission of Fiscal News Shock: Evidence from Defense Spending

ABSTRACTThis paper proposes a novel fiscal news shock transmission channel from the US to Canada. The US and Canada have a long history of strong political and economic ties. This high degree of economic and political interdependence between Canada and the US makes the Canadian economy sensitive to policy changes in the US. We demonstrate that a fiscal news shock originating from a significant increase in US defense spending can directly transmit to Canada through enhanced defense spending in Canada. We construct a transmission model containing the defense spending news variable to assess the transmission of a fiscal news shock through this novel channel. Our findings suggest that news about increased US defense spending induces Canadian defense spending to rise. Consequently, this increased defense spending has a positive impact on the Canadian GDP. The estimated international fiscal multiplier for Canada is 0.11. We coin a novel fiscal multiplier labeled as the international defense multiplier, which quantifies the response of defense spending of a country due to a change in defense spending in another country.KEYWORDS: Fiscal policynews shockdefense spendingdefense multipliershock transmissionJEL CLASSIFICATION: E62F4H56 AcknowledgmentsThe useful comments and constructive suggestions by two anonymous referees are gratefully acknowledged. The usual disclaimer applies.Disclosure statementNo potential conflict of interest was reported by the author(s).Notes1. There are some limitations of the Granger causality test. Especially in a bivariate model like ours, it may be problematic if both variables are driven by a common third process with different lags. The Granger causality tests are designed to handle pairs of variables and may produce misleading results when the true relationship involves three or more variables. However, this test is used in this paper only to motivate the investigation of the transmission of the defense spending news shock rather than the surprise shock from the US to Canada.2. Some of the variables (such as the narrative series of tax change from Romer and Romer (2010), tax changes series from Mertens and Ravn (2012), and the data on excess returns of military contractors) that are used to extract the US defense spending news shock are available until 2007. Therefore, the US defense spending news shock series cannot be extended after 2007 and as a result, we have to limit the sample of this study to 2007.