Appendix B: The New-Area Wide Model
Aschauer, D., 1989b, “Public Investment and Productivity Growth in the Group of Seven,” Economic Perspectives, Vol. 13 (September/October), pp. 17-25.
Calderon, C. and L. Serven, 2003, “The Output Cost of Latin America’s Infrastructure Gap,” in The Limits of Stabilization-Infrastructure, Public Deficits, and Growth in Latin America, ed. by William Easterly and Serven, Washington, World Bank.
Coenen, G. and Roland Straub , 2005, “Does Government Spending Crowd in Private Consumption? Theory and Empirical Evidence for the Euro Area”, International Finance, 8, pp. 435-70.
Coenen, G., P. McAdam and R. Straub, 2007, “Tax Reform and Labour-Market Performance in the Euro Area: A Simulation-Based Analysis Using the New Area-Wide Model”, Journal of Economic Dynamics and Control, forthcoming.
De Haan, J., J. Sturm and B. Sikken, 1996, “Government Capital Formation: Explaining the Decline”, Weltwirrtschaftliches Archiv, 132:1, pp. 55-74.
Easterly, W. and S. Rebelo, 1993, “Fiscal Policy and Economic Growth,” Journal of Monetary Economics, Vol. 32 (December), pp. 417-58.
European Commission, 2003, Public Finances in EMU, European Commission, DG for Economic and Financial Affairs Publication (Brussels, Belgium).
Galí, J., J. López-Salido and J. Valles, 2007, “Understanding the Effects of Government Spending on Consumption”, JEEA, forthcoming.
Gramlich, E., 1994, “Infrastructure Investment: A Review Essay,” Journal of Economic Literature, Vol. 32 (September), pp. 1176-96.
Pappa. E., 2004, “New Keynesian or RBC Transmission? The Effects of Fiscal Policy in Labor Markets,” Working Papers 293, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
Perotti, R., 2004, “Public Investment: Another (Different) Look”, Working Papers 2977, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
Sturm, J., Public Capital Expenditure in OECD Countries: the Causes and Consequences of the Decline in Public Capital Spending, Edward Elgar, Cheltenham, UK.
Turrini, A., 2004, “Public Investment and the EU Fiscal Framework”, European Commission, DG for Economic and Financial Affairs, Economic Paper 202, (Brussels, Belgium).
Valila, T. and A. Mehrotra, 2005, “Evolution and Determinants of Public Investment in Europe”, EIB, Economic and Financial Report 2005-01.
The authors are Economists at the European Central Bank and the IMF’s Asia Pacific Department, respectively. The paper was prepared for the conference on “Fiscal Stabilisation Policies in a Monetary Union: What Can We Learn from DSGE Models?”, European Commission, Brussels, 12—13 October 2006. We appreciate comments and suggestions from Günter Coenen, Matthias Mohr, Matthias Trabandt, Alessandro Turrini, and Harald Uhlig. The views expressed here do not necessarily reflect those of the ECB or the IMF.
See Galí, López-Salido, and Valles (2007) and Bilbiie and Straub (2005) for an analysis of the interaction of rule-of-thumb agents and the effects of fiscal policy.
Public investment is computed as unweighted average of government fixed capital formation across the EU-12 countries. Euro area data shows that public investment was 2.5 percent in GDP in 2005.
For Luxembourg, data is available only from 1990.
These include all EU-12 countries, but Luxembourg.
For example, Portugal.
In calibrating the money-to-consumption ratios, we used data on currency in circulation and overnight deposits held by households for the euro area over the period 1999–2004, while we adopted the calibration by Schmitt-Grohé and Uribe (2005) for the United States.
In our baseline calibration, we further assume that the structural parameters in the euro area and the United States are fully symmetric.
The estimated interest-rate rule in SW (2003) prescribes a feedback of the nominal interest rate to the quarterly inflation rate and the output gap, as well as the first difference in these two target variables, with the output gap being defined in terms of the natural output level; that is, the output level that would prevail in a version of the model without nominal rigidities.
Of course, increasing the relative share of constrained agents will tilt the results in favor of a more pronounced expansion of overall private consumption.
The multiplier is defined as the ratio of the cummulative impulse response functions of output and government spending.
Note that we focus on the study by Perotti (2004) mainly because he claims that his empirical approach is capable of doing away with a number of problem with existing approaches. However, there is a huge body of empirical literature, including one that uses the production function approach, which finds significantly positive effects of public investment on economic activity.
In other words, productive public investment can ultimately be viewed and interpreted as a technology shock to firms’ production process.
This assumes that the Taylor principle holds.
Impulse response functions are approximately symmetric in our analysis, so a negative shock will change the sign but not the magnitude of the response.
Note that the long-run public consumption multiplier is above one following a permanent public consumption shock as has already been demonstrated by Baxter and King (1993) in the neoclassical model.
See Coenen, McAdam, and Straub (2005) for a more detailed description of the model.
In case no distinction between the two households needs to be made, household members will occasionally be indexed by h ∈ [0, 1].
We assume that the members of the foreign household I* are not subject to a financial intermediation premium when trading in international bonds.
For simplicity, it is assumed that dividends are taxed at the household level.
The existence of state-contingent securities is assumed for analytical convenience and renders the model tractable under staggered wage setting with household members supplying differentiated labour services.
This in turn guarantees that Ci,t = CI,t in equilibrium.
Notice that the first-order condition (11) implies that the intensity of capital utilization is identical across household members; that is, ui,t = ut.
The markup depends on the intratemporal elasticity of substitution between the differentiated labour services supplied by the members of household I, which in turn determines the firms’ price elasticity of demand for these services.
The fixed cost of production will be chosen to ensure zero pro_ts in steady state. This in turn guarantees that there is no incentive for other firms to enter the market in the long run.
In principle, the two household-specific bundles of labour services could be distinguished by differences in skill levels across households, resulting in a larger dispersion of wage income which may ultimately provide a rationale for the existence of liquidity constraints on the part of the low-income household.
The markup depends on the intratemporal elasticity of substitution between the differentiated goods supplied by the intermediate-good firms to the domestic final-good firms, which in turn determines the final-good firms’ price elasticity of demand for the differentiated intermediate goods.
While our treatment of the adjustment cost as being external to the firm would formally involve assuming the existence of a large number of firms with appropriate adjustments in notation (see, e.g., Bayoumi, Laxton and Pesenti, 2004), we abstract from these adjustments for ease of exposition.
Notice that even in the absence of import adjustment cost, the prices of the consumption and investment goods may differ due to differences in the import content.
See Coenen, McAdam and Straub (2005) for details.
Notice that the existence of a financial intermediation premium guarantees that, in the non-stochastic steady state, holdings of internationally traded bonds are zero worldwide.