A. Key Model Features

This section highlights some key model features that are useful to interpret the results.

Non-Ricardian features. The model includes several non-Ricardian features that make revenue and expenditure fiscal measures non-neutral, both in the short and long terms. In order of quantitative importance, these features include (i) overlapping generations (OLG) agents with finite lifetimes and therefore with high subjective discount rates; (ii) life-cycle income profiles that make wealth less dependent on future labor income; (iii) liquidity-constrained agents; and (iv) distortionary taxes on labor income, capital income, consumption, and imports.

Nominal and real rigidities. GIMF includes multiple nominal and real rigidities in labor markets and also in intermediate and final goods markets that result in a cascade of price rigidities as goods are traded along the production chain from primary producers to final retailers. Real rigidities include habit persistence in consumption; quantity adjustment costs in the retail sector; investment adjustment costs and variable capital utilization; and imports’ adjustment costs and productivity spillovers. Nominal rigidities are included as price adjustment costs by firms, and nominal wage rigidities.

Growth. Steady-state growth is exogenous with the world economy growing at a constant rate. Population also grows at a constant rate.

Asset markets. Asset markets are assumed to be incomplete. There is complete home bias in government debt, so that all debt is held by domestic investors in the form of nominal, one-period bonds denominated in domestic currency. The only internationally traded assets are nominal one-period bonds denominated in foreign currency. Firms are also owned domestically, and households receive lump-sum dividend payments from their shareholding in domestic firms. The commodity sector is owned by both domestic and foreign households.

Risk premium. Risk premium takes the form of a foreign exchange risk premium and a sovereign risk premium. The foreign exchange risk premium is a non-linear function of current account to GDP ratio, so that the risk premium becomes higher—and at an increasing rate—as the current account deficit becomes bigger. The sovereign risk premium is set to be exogenously, and therefore it is independent from fundamentals.

Monetary policy. The monetary authority responds to economic developments and seeks to achieve an inflation target. The policy interest rate responds to inflation (concurrent and one-period-ahead forecast), the size of the inflation gap, and to lagged interest rates.

B. Economy Sectors

In broad terms, the GIMF structure includes the following framework, replicated for all three regions:

Households. There are two types of households: overlapping generations’ (OLG) households with finite planning horizons (Blanchard, 1985), and liquidity constrained households (LIQ). Households consume final retailed output and supply labor to unions. Both types of households are subject to uniform labor income, consumption, and lump-sum taxes. Their income also derives from financial assets (domestic government and corporate bonds in domestic currency), international private bonds in foreign currency, and ownership of domestic firms. Households supply labor to unions. OLG households have several investment options: finance entrepreneurs through bond purchase; make bank deposits (non-contingent return), and own firm shares that yield dividends.

Firms. The production structure of the economy includes several stages, which range from primary producers to retail distributors. Each stage includes a combination of frictions in price setting and acquisition of inputs that results in a parsimonious response to shocks and also to changes in economic policy. Primary production is carried by manufacturers producing tradable and non-tradable goods. For inputs, manufacturers buy capital services from entrepreneurs, labor from monopolistically competitive unions (who buy labor from households and are subject to nominal wage rigidities), and raw materials from the world raw-materials market. Entrepreneurs receive loans from banks (subject to a zero-profit competitive constraint), which take households’ deposits. Entrepreneurs then purchase capital and rent it to manufacturers, and decide the rate of capital utilization, which is subject to increasing utilization costs. In addition, the capital stock is subject to shocks that can result in bankruptcy and undermine entrepreneurs’ loan repayment ability. Banks are subject to monitoring/state verification costs. Manufacturers are subject to nominal rigidities in price setting, and also to real rigidities in labor hiring and in the use of raw materials. Capital goods’ producers are subject to investment adjustment costs, and finance their activities from a combination of domestic and foreign sources. Manufacturers’ domestic sales are purchased by distributors, while foreign sales are purchased by import agents that are domestically owned but are located in each export destination region (who then sell their product to foreign distributors).

Distributors. A distribution sector assembles non-tradable goods along with domestic and foreign tradable goods with imported inputs, with changes in the latter being subject to adjustment costs. This private sector output is then combined with a publicly-owned capital stock (infrastructure) and foreign output in order to produce domestic final output which is sold to consumption goods’ producers, investment goods producers, and to final goods import agents located at foreign country. Distributors are subject to nominal rigidities (sticky price setting). Consumption goods output is sold to retailers and the government; investment goods output is sold to domestic capital goods producers and the government.

Retailers. A monopolistically competitive retail sector sells the goods to consumers at flexible prices, but with adjustment costs associated with changes in sale volumes. This feature contributes to generate inertial consumption dynamics, allowing a smoother path of consumption consistent with time series data. Retailers combine final consumption good composite from consumption goods producers and raw materials from raw materials producers. They are subject to adjustment costs to changes in raw material inputs. Their price setting is subject to real rigidity by way of costly adjustments of sale volume to changes in demand.

View Full Size

Simplified Presentation of GIMF Sectors ^1/

Citation: IMF Working Papers 2013, 207; 10.5089/9781484305225.001.A001

^1/ Arrows indicate flow exchange of goods and/or services among sectors. These sectors are replicated for each of the three regions. A more detailed diagram representation can be found in KLMM.

• Download Figure
• Download figure as PowerPoint slide

Government. The government utilizes domestic and foreign inputs to produce a government consumption good. In addition, the government spends in public capital (infrastructure), which is used as an input in private production, as explained above. Finally, the government also makes lump-sum transfers to households. Government expenditures are financed with debt issuance, and several forms of distortionary taxes (as mentioned above), plus lump sum taxes. This means that fiscal policy consists of public investment, public consumption, transfers to HH, lump sum taxes, consumption taxes, investment income taxes, and labor taxes. Notice that the production of a government good is introduced to allow import content in government output (often high content of investment goods and low content of consumption goods). Government allocation of resources therefore plays a key role for the real economy, especially as government investment augments the stock of infrastructure and results in protracted and long-lasting effects on private investment, and labor supply and demand. Fiscal policy is modeled so that it complies with two objectives: debt sustainability, and cycle smoothing. Non-explosive debt dynamics are ensured adjusting expenditure to stabilize the overall fiscal balance at a long-run level chosen by policy (long-run debt ratio target). Stabilization of the business cycle is achieved through a structural balance rule that responds to the size of the output gap.³

Consolidation of Government Investment

A fiscal consolidation achieved by cutting public investment appears as the least desirable option, both in the short and long terms. The impact on output is the most severe and protracted of all instruments considered (Figure 3). There is a sustained decline in GDP relative to baseline of about 1 percentage point every five years for every percentage point of fiscal consolidation. By 2025 GDP is three percent lower than baseline, and five percent by 2050.

View Full Size

Impact of 1 Percent of GDP Permanent Fiscal Consolidation on National Accounts

(Differences relative to the case of no consolidation, in percent)

Citation: IMF Working Papers 2013, 207; 10.5089/9781484305225.001.A001

• Download Figure
• Download figure as PowerPoint slide

Aggregate demand declines immediately by about 0.5 percent of GDP. This reduces firms’ demand for both capital and labor in the short term. As government investment is lower, the stock of public capital declines. This gradually reduces productivity and undermines potential output. The decline in demand of factors of production therefore becomes protracted, and households’ incomes and consumption progressively erode over time (Figure 3). Private investment declines over time, resulting in a reduction in total real investment that accumulates to around two percent of GDP below baseline after 10 years. As the stock of private capital declines, the amount of investment necessary to maintain it at the desired level is lower.

The external sector balance improves initially in about the same magnitude as the fiscal balance (Figure 3), but this improvement gradually erodes as the economy looses competitiveness over time (Figure 4). This improvement is explained broadly ½ by an increase in exports and ½ by a decline in imports. Interestingly, there is real exchange rate appreciation, mainly as the protracted consumption decline is slower than the decline in output, a result driven by habit persistence in consumer preferences⁸.

View Full Size

Impact of 1 Percent of GDP Permanent Fiscal Consolidation on Inflation, Exchange Rates and Interest Rates

(Differences Relative to the Case of No Consolidation, in Percent)

Citation: IMF Working Papers 2013, 207; 10.5089/9781484305225.001.A001

• Download Figure
• Download figure as PowerPoint slide

Consistent with these developments, there is a decline in inflation and interest rates that is largest in magnitude compared to other forms of consolidation (Figure 4). Consumer and core inflation decline 0.1 percentage points below baseline in the short term, with this decline picking by year three at near 0.2 percentage points. The net effect is also a decline in real interest rates, as de-investment across sectors materializes. The decline in real wages is the most significant when comparing across all consolidation instruments considered, at 1 percent after five years, and more than 3 percent in the long–term (beyond the time horizon span shown in the chart in Figure 4).

Consolidation of Government Consumption

If fiscal consolidation is achieved with a reduction of government consumption in goods and services and/or wage expenditures, aggregate demand declines in the short-term about ¼ percent below baseline (Figure 3). Afterwards it recovers, but only partially, remaining short of the baseline level. Notice that this result would in general be different to the predicted fiscal multiplier of a fiscal stimulus, which is a transitory policy by definition. In sharp contrast with a cut in public investment, private investment remains almost unaffected, and private consumption increases to almost fully offset the decline in public consumption. The current account balance improves proportionally, with roughly a ½ split between an improvement in exports and a decline in imports. This mild economic response is largely explained by the high degree of openness of the Hungarian economy. The demand impact from public consumption retrenchment has a large impact on the demand of imports, rather than on domestic goods.

Inflation decline is minimal, and the nominal and real exchange rate show a small amount of depreciation that peaks in the first year at 0.2 percent compared to baseline (for both core and CPI). Real wages decline by less than 0.5 percent in the short–term, and partially recover over the long-term

Consolidation of Government Transfers—General and Targeted

The initial impact of a cut in transfers on output is mute (Figure 3). Consumption declines immediately and in the same amount as the transfers’ cut. Moreover, output increases in the medium and long term relative to baseline, and more so in the case of a cut in targeted transfers (0.4 percent of GDP relative to baseline) than in the case of general transfers (0.1 percent). The current account balance improves relative to baseline, but less than in the cases of consolidation via government consumption and investment analyzed above. The current account improves by 0.4 percent of GDP on impact, and continues to improve over time to stabilize at around 0.8 percent of GDP above baseline. This different current account behavior is the result of a milder decline in imports than in the two cases above.

The muted impact on output in the short term is explained by the endogenous response of the economy. Unlike in the case of a consolidation cutting public investment, total investment remains virtually unaffected. As households disposable income is reduced with the cut in transfers, labor participation increases, boosting output and having an offsetting effect. With lower overall household income the decline in consumption becomes protracted and results in permanent currency depreciation in real terms (mainly from a nominal depreciation). Moreover, the currency depreciation reduces the producer-cost of labor, further increasing the demand for labor and output. All in all, the improvement in external competitiveness allows output to remain at the same level as in baseline in the short term despite a decline in private consumption as the external demand offsets the decline in domestic demand.

Over the medium and long terms, the improvement in competitiveness results in higher output permanently. The increases in labor participation and labor demand explained above is large and protracted, given the permanent nature of the cut in transfers. In addition, the gradual reduction in government debt reduces interest rates further, creating fiscal space which in the simulation is allocated to government consumption and provides further stimulus to aggregate demand. This allows some reversal of the short-term improvement in external accounts (Figure 4). In addition, the sustained improvement in the external balance results in private sector accumulation of net foreign assets, and a gradual increase in the non-wage income of the OLG (forward-looking non-myopic) consumers. This last effect reduces the negative short-term impact of the cut in transfers and contributes to the gradual recovery in consumption.

The dynamics analyzed above are more pronounced in the case of a cut in transfers that are targeted to liquidity-constrained agents, in comparison with the case of a cut in general transfers. As liquidity-constrained agents do not accumulate assets by assumption, they have less room to cushion the decline in income with other sources of income and savings, and their response is more pronounced (also because the same amount of fiscal consolidation is concentrated in a smaller number of households).

Consolidation with Consumption Taxes

Increasing consumption taxes permanently to achieve an improvement in the overall balance of 1 percent of GDP reduces growth by 0.2 percent in the first year (Figure 3). Afterwards, GDP growth recovers in a small amount, but never back to baseline levels. Private consumption, however, declines significantly, more than in any other policy instrument considered. Real consumption declines 1 percent of GDP in the first year, 1.5 percent by the third year, and recovers gradually afterwards. The recovery, however, is explained in part by the assumption on the allocation of the fiscal space created by the reduction in public debt to government consumption, as explained above.

The external accounts improve, as expected, but, interestingly, less so than under a reduction in government investment and government consumption (Figure 3). The current account balance increases gradually to reach 0.8 percent of GDP by year three and stabilizing below 1 percent of GDP in the long–term. This is determined by an increase in exports that peaks at 0.4 percent of GDP by year three and a contraction in imports that is somewhat more protracted and peaks also at near 0.4 percent of GDP. Inflation declines to 0.02 percentage points below baseline over the first three years, as the impact on prices of a decline in consumption offsets the price level effect of taxes, but then recovers back to baseline in the long–term (Figure 4). Interest rates also reflect the lack of demand and move downward, while the nominal exchange rate depreciates by less than 0.2 percent, and allows a real exchange rate depreciation of about the same amount. This exchange rate depreciation is very protracted.

The results above indicate that there is a contractionary effect, including a decline in growth, inflation, interest rates, and exchange rate depreciation. This contraction, however, is small relative to the size of the consolidation. The decline in output is less than ¼ the size of the improvement in the fiscal surplus targeted, and inflation, interest rate, and exchange rates show relatively small changes. The reasons behind this result are twofold. First, the increase in consumption taxes stimulates savings. As a result forward looking (OLG) consumers internalize an increase in wealth income, which moderates the decline in consumption (aided also by habit persistence in consumption). The decline in interest rates also increases investment and the capital stock, moderating the decline in output as time passes. This also explains why real wage declines, as determined by a lower demand, but less so than under other consolidation options (0.2 percent below baseline by year three, protracted). Second, with Hungary being a very open economy, the external balance improves considerably, more than ¾ the size of the consolidation, as the exchange rate depreciates in real terms. This implies that the switching effect from domestic to external demand is relatively large, cushioning the domestic demand impact.

Consolidation with Corporate Income Taxes

A consolidation with taxes on corporations is contractionary in the short–term, and becomes significantly more so in the medium term, second only to a reduction in government investment. Output declines 0.4 percentage points below baseline in the first year, then 0.5 percent by year five, and continues to stimulate a steady decline in output that peaks after ten years, at 1.5 percentage points below baseline (Figure 3). The main driver of this result is a decline in private investment, which is sustained for a long period of time until the point the capital stock reaches its desired level. Indeed, investment over 5 percentage points below baseline in year 1, and more than 8 percentage points by year 3, when it reaches its lowest point. This investment decline is far more significant than in any other of the policy alternatives considered. It is interesting to notice that in year 1 private consumption declines to 0.6 percent below baseline, which is about ½ of the decline that would be obtained under the other two tax alternatives and also if government transfers were reduced. This indicates that the distributional impact of this option is, however, not without cost. Notice that real wages also exhibit a significant decline, of about the same magnitude than the one predicted under a decline in government investment during the first five years after the policy is implemented. By year five real wages are 1 percent below baseline, and remain at around that level thereafter (Figure 4).

The external accounts show the biggest improvements in the short term of all policy alternatives under analysis. The improvement in the current account balance peaks at 1 ½ percent of GDP by year 3 (Figure 3). Of this, about 1 percent is due to a contraction in imports, which in this case are augmented by the decline in imports of investment goods, and ½ percent by an increase in exports.

Inflation decline is of more than 0.1 percent below baseline, consistent with the general decline in aggregate demand and output. This is not a big amount, but is the second largest decline when comparing across the consolidation alternatives. The same observation applies to nominal and real interest rates. As with the case of a cut in government investment, the real exchange rate appreciates, a result that appears unintuitive given that the decline in output and demand is second to largest. The underlying reasons are the same as in the case of government investment consolidation.

Consolidation with Labor Taxes

A consolidation by increasing labor taxes reduces GDP by 0.3 percentage points below baseline in the first year, and the decline continues to increase until year 5 at 0.6 percentage points below baseline (Figure 3). This decline is larger than obtained by cutting government consumption or transfers, and broadly in line with corporate income taxes in the initial years. However, unlike in the cases of corporate taxes and government investment, output recovers after year 5, although this recovery is slow and driven mainly by the assumption of the allocation of fiscal space resulting from public debt reduction to government consumption. The underlying forces behind this decline in output, however, are different than in these two alternative policy options. The main driver is a decrease in labor participation. Evidence of this is that it is the only policy alternative that results in an increase in real wages (Figure 4). As a result, the return to capital declines and investment is reduced (¾ percentage points below baseline by year 3). With lower household incomes, consumption declines in the short term significantly, almost on par with the result under a cut in consumption taxes, which showed the deepest departure from baseline. This decline is also very protracted, as the reduction in investment further reduces the demand for labor and the initial real wage increase gradually reverses.

The improvement in the external sector is the smallest across all the consolidation alternatives. The improvement of the current account is near 0.4 percent of GDP in the first year, and gradually increases to around 0.6 percent in the long term. This improvement is mainly driven by the decline in domestic demand, of both private consumption and investment, and therefore it is more protracted than in the other alternatives. Exports improvement is the lowest of all alternatives up until year five, when it is 0.3 percent of GDP above baseline.

Inflation and interest rate dynamics show a minor decline in the near term, remaining below baseline, but then increase to above baseline and remain there after year 3 (Figure 4). This behavior is consistent with the patterns of labor participation and investment explained above. The quantitative values of these changes, however, are not significant.