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Corsetti: European University Institute, University of Rome III, and CEPR; Meier: International Monetary Fund; Müller: University of Bonn. We are grateful for comments from Peter Doyle, Charles Kramer, Evi Pappa, and participants in the 4th Annual Workshop on Global Interdependence. Corsetti and Müller gratefully acknowledge generous financial support from the Fondation Banque de France and the Pierre Werner Chair Programme on Monetary Union.
The importance of expectations about the future policy stance for understanding fiscal transmission has been emphasized by the literature following Giavazzi and Pagano (1990)—see, for example, Bertola and Drazen (1993), Sutherland (1997), Balduzzi, Corsetti, and Foresi (1997), and Perotti (1999). Yet these contributions focus on expected large fiscal corrections which lower the overall tax burden of the private sector. Our results, in contrast, rely on partial spending corrections after an initial expansion of government spending, thus characterizing endogenous iscal dynamics in normal times.
Monacelli and Perotti (2008), for instance, reconsider the role of non-separable GHH preferences to generate complementarity between hours worked and consumption. Ravn et al. (2007), in turn, posit the existence of ‘deep habits’. While these approaches hold considerable promise, they maintain commonly employed, but restrictive assumptions on the conduct of fiscal policy, especially the assumption that any temporary rise in government spending eventually entails a one-for-one increase in the tax burden.
We consider a small open economy model, which allows us to abstract from a possible feedback of domestic developments on the rest of the world. This assumption considerably simplifies the analysis and the intuitive account of the fiscal transmission mechanism with spending reversals, as does abstracting from capital formation. Results from a two-country version of the model with explicit investment decisions (while requiring a somewhat more complex exposition) are in line with those reported below. They are available upon request.
To rationalize decreasing returns (α < 1), one may think of a firm-specific capital stock which is prohibitively costly to adjust at business cycle frequency.
Our particular specification draws on Kollmann (2002), who studies a model similar to ours. Schmitt-Grohé and Uribe (2003) consider a real model of a small open economy and suggest the above mechanism of a debt-elastic interest rate as one among several ways of ‘closing small open economy models’ (that is, inducing stationarity) with incomplete markets. In principle, a debt-elastic interest rate also provides a convenient, if somewhat crude, way to study another possible transmission channel of fiscal policy. Specifically, a non-negligible ‘risk premium’ (i.e., x taking an economically signiicant value) would capture the idea that borrowers from highly indebted countries face less favorable inancing conditions in international markets. This, in turn, would affect the real economic impact of higher government spending. We briefly consider this idea in the appendix to the paper.
If, in addition λ = 0, the relative magnitude of ψtg and ψtd is irrelevant for the equilibrium allocation, provided that ψtd is set so as to ensure the stability of debt.
See Galí, Gertler, and López-Salido (2001) or Eichenbaum and Fisher (2007) for further discussion of how real rigidities interact with nominal price rigidities in the context of the new Keynesian model. Note that the latter study also considers a non-constant price elasticity of demand, which further increases the degree of real rigidities.
Consider a linear approximation of the equilibrium conditions around a deterministic steady state with zero inflation and without debt. Abstracting from autocorrelation of government spending and any direct contemporaneous response of taxes to spending, and assuming an ‘active monetary policy’, debt stability obtains if the difference between ψgd and ψtd does not exceed 1 — β. For a general discussion see Leeper (1991).
We should stress that our parameter choice does not necessarily reflect explicit debt or deficit constraints as enacted in several countries. Instead, a systematic adjustment of spending and/or taxes to the level of public debt may follow, more broadly, from political economy constraints which force fiscal adjustment to take place at some point. For instance, Canova and Pappa (2004), find a strong stabilizing response of government spending to the debt output/ratio across U.S. states, irrespective of whether state laws mandate explicit fiscal restrictions.
Using annual observations, Galí and Perotti (2003), for instance, report estimates ranging from -0.04 to 0.03 for government spending, and from 0 to 0.05 for taxes, in a panel of OECD members (no breakdown by country provided for these estimates). For the U.S., Bohn (1998) reports estimates for the response of the surplus to debt in a range from 0.02 to 0.05.
The lexible-price allocation is modeled by assuming that the central bank adjusts interest rates massively in response to any deviation of inflation from the target. Specifically, we assume ϕ = 500.
The long-term real rate of interest is defined as the real yield on a bond of infinite duration. Formally, the deviation of this variable from its steady-state value corresponds to the infinite sum of deviations of future ex-ante short-term real interest rates from steady state.
With additive separability of preferences over time, the equilibrium consumption demand is determined exactly by the negative of the long-term real interest rate—see, for example, Woodford (2003) p. 244.
With complete markets, the real exchange rate would be determined exactly by the ratio of domestic to foreign long-term real interest rates, see, for example, Corsetti and Pesenti (2005) and Galí and Monacelli (2005). Observe that our allocation turns out to be close to the one under complete markets, as shown by Figure A.1 in the Appendix—for further discussion see also Corsetti et al. (2008).
Our specification of the tax rule implies that taxes rise, on impact, by 50 percent of the spending impulse, thus causing a deficit to emerge.
A stronger depreciation obtains if we allow for a (significantly) debt-sensitive interest rate (χ = 0.1), capturing the notion that higher public debt could trigger a rise in risk premia on residents’ external borrowing, see Figure A.2.
The response of the real wage to government spending shocks has received considerable attention in the literature following Rotemberg and Woodford (1992), who documented an increase for U.S. data. While the neoclassical model predicts a decline in the real wage, new Keynesian models typically predict an increase. The reason is that while labor supply increases in both models, labor demand increases only in the new Keynesian setup—see Pappa (2005) for a recent investigation.
A third approach is based on sign restrictions—see Mountford and Uhlig (2008), Canova and Pappa (2004, 2007), and Enders, Müller, and Scholl (2008). Also, more recently, Romer and Romer (2008) have used their ‘narrative’ approach, developed in the context of monetary policy analysis, to identify tax shocks.
In fact, as our sample starts in 1980, it would include only one of the narrow Ramey-Shapiro military events, namely an increase in defense spending following the 9/11 terrorist attacks in 2001. The new military variable data, instead, contain additional episodes, such as the fall of the Berlin Wall.
In fact, Chung and Leeper (2007) apply the criterion of Fernandez-Villaverde, Rubio-Ramirez, Sargent, and Watson (2007) to show that small VAR systems are likely to be non-invertible relative to more comprehensive VAR systems which include public debt.
Indeed, the empirical response of interest rates to fiscal policy shocks has been a topic of extensive debate—see, for example, Perotti (2004) and Favero and Giavazzi (2007). Recently, Laubach (2007) has investigated the relationship between long-horizon forward interest rates in the U.S. and changes in the fiscal outlook as projected by the Congressional Budget Office. While he finds a positive and significant relationship with projected levels of government spending, his empirical strategy is explicitly geared toward neutralizing the effects of (i) the business cycle and (ii) monetary policy on interest rates. By contrast, we are primarily interested in the effect of government spending shocks on interest rates for a given monetary policy rule.
A noteworthy exception in this literature is Beetsma, Giuliodori, and Klaasen (2008), who document a real appreciation for a sample of European countries. Also, in their analysis of U.S. states and EMU member countries, Canova and Pappa (2007) document that government spending shocks rise the price level relative to the union—thus suggesting real appreciation. In Corsetti, Meier, and Müller (2009), we explore systematically the role of the exchange rate regime for the fiscal transmission mechanism.
Favero and Giavazzi (2007) add government debt to a VAR model estimated on U.S. data and compare results for 1960-1979 and 1980-2006. For the later sample, they find no spending reversals during the first 20 quarters after the shock (for which responses are reported), but the response of government spending to spending shocks is considerably less persistent relative to a VAR model without debt. Moreover, they find a significant negative response of government spending to the change in debt, while taxes tend to increase, i.e., both adjust to stabilize debt.