Abrego, Lisandro, and Pär Österholm, 2008, “External Linkages and Economic Growth in Colombia: Insights from a Bayesian VAR Model,” IMF Working Paper WP 08/46 (Washington: International Monetary Fund).
Gómez, Javier, José Darío Uribe, and Hernando Vargas, 2002, “The Implementation of Inflation Targeting in Colombia,” Borradores Semanales de Economía, No. 202.
Kumhof, Michael, and Douglas Laxton, 2007, “A Party Without a Hangover? On the Effects of U.S. Government Deficits,” IMF Working Paper No. 07/202 (Washington: International Monetary Fund).
Leigh, Daniel, 2008, “Achieving a Soft Landing: The Role of Fiscal Policy,” IMF Working Paper WP/08/69 (Washington: International Monetary Fund).
Prepared by Benedict Clements, Enrique Flores, and Daniel Leigh.
See, for example, Kumhof and Laxton (2007). Examples of large-scale models used for monetary policy analysis include the Banco de la República’s Model of Transmission Mechanisms (MMT), the IMF’s FPAS and GEM, the Federal Reserve’s SIGMA, and the ECB’s NAWM.
These consumers solve an intra-temporal optimization problem for choosing consumption and leisure levels. However, without access to financial markets, they cannot smooth consumption in response to temporary changes in disposable income.
The rule is implemented by modifying tax rates to achieve the desired objective.
There are two financial assets in the model, private bonds that are traded internationally, and government bonds that are subject to complete domestic bias.
If the risk premium ρt = 0, an expected depreciation of the domestic currency by 1 percent is, via arbitrage, associated with an increase in the domestic interest rate by about 1 percentage point above the rest-of-the-world interest rate.
Another option would be recalibrate the model and assume a more adverse relationship between the debt to GDP ratio and interest rates. However, given that the change in the deficit may trigger changes in expectations in a non-continuous fashion, we simulated this with an upward shift in the exogenous component of the interest rate equation.
The delayed response is simulated by mechanically increasing the inertia of monetary policy for the two quarters following the shock.
The model assumes a monetary policy reaction function similar to that in the Banco de la República’s MMT. Fiscal policy is assumed to follow a constant deficit rule.
The coefficient of persistence of nominal rates is increased to .99 in the first and second quarters following the shock and to .75 in the third and fourth quarter. The coefficient is set to 0.5 in the following years.
The constant deficit rule assumed under the baseline policy response is procyclical, as the decline in taxes resulting from the reduction in output would need to be matched by spending cuts.
Calculated for the first five years following the shock.