On the stock market reactions to fiscal policies

• Author: Oreste Napolitano,Pasquale Foresti
• Date: 01 October 2017
• Published date: 01 October 2017
• DOI: http://doi.org/10.1002/ijfe.1584

Received: 16 October 2014 Revised: 13 May 2017 Accepted: 25 August 2017

DOI: 10.1002/ijfe.1584

RESEARCH ARTICLE

On the stock market reactions to fiscal policies

Pasquale Foresti1,2 Oreste Napolitano3

1The London School of Economics and

Political Science, London, UK

2Coventry University, Coventry,UK

3University of Naples Parthenope, Naples,

Italy

Correspondence

Pasquale Foresti, EuropeanInstitute, The

London School of Economics and Political

Science, Houghton St, London WC2A

2AE, UK.

Email: p.foresti@lse.ac.uk

Abstract

In this paper, a panel analysis is employed to investigatethe effects of fiscal poli-

cies on stock market indexes in 11 members of the Eurozone.Many studies have

focused on the effects of monetary policy on the stock market, whereas the num-

ber of contributions studying the effects of fiscal policy on the stock market is

surprisingly limited. Therefore, we know little, if any, on the sign and stability of

the stock market reaction to fiscal policies. Our results show that fiscal policies

influence the stock market and that, following an increase (decrease) in public

deficit, stock market indexes go down (up). Nevertheless, further analysis shows

that the signs of the estimated stock market reactions are not constant over time

and that they change according to the surrounding macroeconomic scenario.

KEYWORDS

Eurozone, fiscal policy, stock market, panel DOLS

1INTRODUCTION

Over the last decades, important economic events have

captured the attention of policymakers and academics

towards the effects of fiscal policies. In the context of the

Eurozone, relevant issues refer to the governments' deficit

and debt limits coupled with the independency of national

fiscal policies, the sudden occurrence of the global finan-

cial crisis, and the sovereign debt crisis affecting some

member countries. All these events have called for the

assessment of the fiscal policy effects on the general level

of economic activity, assets markets, credit markets, and

net exports.

The aim of this paper is to examine the effects of fis-

cal policies on the stock market on the basis of a panel

of 11 member countries of the Eurozone with quarterly

data spanning the period 1999:Q1–2012:Q1. Despite the

fact that several studies have analysed the reaction of the

stock market to monetary policies, the number of contribu-

tions focusing on the effects of fiscal policies on the stock

market is surprisingly scarce.

The effects of fiscal policy on the level of economic activ-

ity are the subject of a long-lasting debate in economic

theory. There are three ways of modelling such effects

according to the fact that an economic system is intended

to function in a Keynesian, Classical, or Ricardian fashion.

Keynesian economics focuses on the effects of the fis-

cal multiplier and assumes that increasing primary public

deficit causes an increase in the level of economic activity.

By applying a Ricardian view,another part of the economic

theory assumes that fiscal policy has no effects on the

level of economic activity.Based on the Ricardian view and

on the Classical economics concept of the crowding out

effect, another stream (called as the non-Keynesian view,

NKV) provides evidence for possible contractionary effects

of fiscal spending (non-Keynesian effects of fiscal policies).

Depending on the view adopted, the understanding and

prediction of the stock market reaction to fiscal poli-

cies change completely. If stock market operators assume

Keynesian effects of fiscal policies, the effects of pub-

lic deficits expansions on the stock market are supposed

to be positive. If stock market agents assume a pure

296 Copyright © 2017 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/ijfe Int J Fin Econ. 2017;22:296–303.