Mika Kortelainen. Adjustment of the US current account deficit

Transcription

1 Mika Korelainen Adjusmen of he US curren accoun defici Bank of Finland Research Discussion Papers

2 Suomen Pankki Bank of Finland P.O.Box 160 FI HELSINKI Finland hp://

3 Bank of Finland Research Discussion Papers Mika Korelainen* Adjusmen of he US curren accoun defici The views expressed are hose of he auhor and do no necessarily reflec he views of he Bank of Finland. * Corresponding auhor. Tel.: ; fax: address: mika.korelainen@bof.fi. I hank Juha Kilponen, Juha Tarkka, Jouko Vilmunen, and Mai Virén for helpful commens. I also hank Reijo Siiskonen for daa suppor. I am solely responsible for remaining errors and omissions. This paper can be downloaded wihou charge from hp:// or from he Social Science Research Nework elecronic library a hp://ssrn.com/absrac_id=

4 hp:// ISBN ISSN (prin) ISBN ISSN (online) Helsinki 2007

5 Adjusmen of he US curren accoun defici Bank of Finland Research Discussion Papers 9/2007 Mika Korelainen Moneary Policy and Research Deparmen Absrac We presen a wo counry DGE model and esimae i using Bayesian echniques and euro area and US quarerly daa for In analysing he curren accouns we find ha a lower US rae of ime preference or a higher dollar risk premium could render he defici susainable, bu ha hese could push he ineres rae o he zero bound. Secondly, we find ha fiscal policy is no sufficienly effecive o improve he curren accoun alhough he zero bound is no hi. Key words: curren accoun, zero bound, policy coordinaion JEL classificaion numbers: E61, F32 3

6 Yhdysvalojen vaihoaseen vajeiden sopeuuminen Suomen Pankin keskuselualoieia 9/2007 Mika Korelainen Rahapoliiikka- ja ukimusosaso Tiiviselmä Tässä ukimuksessa esiellään kahden maan DGE-malli ja esimoidaan se käyäen Bayesin meneelmiä euroalueen ja Yhdysvalojen neljännesvuosiaineisolla vuosila Vaihoaseanalyysissä havaiaan, eä aikapreferenssinaseen lasku Yhdysvalloissa ai dollarin riskipreemion kasvu voiva palauaa Yhdysvalojen vaihoaseen vajee kesävälle asolle, mua samalla korko saaaa laskea nollakorkorajalle. Lisäksi havaiaan, eä finanssipoliiikka ei kykene riiävän ehokkaasi vähenämään vaihoaseen vajeia, vaikka koro eivä laske nollakorkorajalle. Avainsana: vaihoase, nollakorkoraja, koordinoiu poliiikka JEL-luokielu: E61, F32 4

7 Conens Absrac...3 Tiiviselmä (absrac in Finnish) Inroducion Model Households Firms Governmen Foreign counry Equilibrium Maching model o daa Daa Calibraion Esimaion Validaion Impulse response funcions Adjusmen of he US curren accoun defici An increase in US household savings An increase in dollar risk premium Uncoordinaed fiscal policy A coordinaed fiscal policy Discussion Conclusions...30 References

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9 1 Inroducion One of he main opics of concern in recen debae over economic policy has been he growing curren accoun defici in he Unied Saes. In pracice, his means he Unied Saes is moving deeper and deeper ino deb o he res of he world. On he oher hand, he res of he world has been willing o finance he US defici and inves in US dollar-denominaed financial asses insead of, for example, invesing in heir own domesic markes. The US curren accoun defici has grown in recen years and currenly sands a 6.6% of GDP (see Bureau of Economic Analysis 2006). The defici sems largely from he rade accoun, which has been subsanially in he red. The curren accoun defici has raised US ne foreign deb o more han 20% of GDP. This amouns o around 200% of he value of he counry s expors in goods and services. On he oher hand, he US deb burden is lessened by he fac ha ouward invesmen from he Unied Saes o he res of he world yields a higher reurn on average han inward invesmen in he US marke. Thus, he US invesmen income balance (ineres and dividends paid) has only recenly moved ino defici. If he Unied Saes coninues o accumulae foreign deb, however, he ineres paymens on deb will sar conribuing o a furher deepening of he curren accoun defici. Has he US curren accoun defici grown oo large? Since he curren accoun defici is also he difference beween domesic savings and invesmen, his quesion can be rephrased: Can he Unied Saes presen consumpion and invesmen demand be susained a curren levels of deb and capial? We may furher ask wha would happen if invesors in he res of he world were no longer willing o finance he US defici. Wha consequences would his have for exchange raes and for he US and oher economies around he world? In he recen lieraure, he US curren accoun defici has been analysed eg by Obsfeld and Rogoff (2004), Faruqee e al (2005), and Erceg e al (2005a). In Obsfeld and Rogoff (2004) a sylised general equilibrium model is used o analyse he effecs of an immediae adjusmen of he curren accoun defici. This analysis assumes ha he whole defici is unsusainable and hus he adjusmen is associaed wih large changes in real exchange rae and erms of rade. Moreover, he model does no incorporae any dynamic opimisaion decisions and is hus more suiable for long-run analysis. Erceg e al (2005a) use an open economy DGE model o analyse he quaniaive effecs of fiscal shocks on he US rade balance. They find ha changes in fiscal policy have small effecs on he US rade balance, irrespecive of wheher he source is a spending increase or a ax cu. They find also ha an increase in he fiscal defici of one percenage poin of GDP causes he rade balance o deeriorae by less han 0.2 percenage poin. All in all, heir resuls 7

10 sugges ha a large reducion in he US governmen defici would no play a major role in correcing he curren accoun imbalance. Faruqee e al (2005) use he IMF's Global Economy Model o conduc some ineresing simulaions. In heir baseline scenario, he US defici reurns o a susainable level as he shocks ha hi he US and world economies fade away. This baseline adjusmen is seen as a relaively smooh process even hough he real ineres rae increases considerably in he Unied Saes. In an alernaive scenario, a sudden porfolio reshuffling in he res of he world resuls in higher US real ineres raes, and a weaker dollar, wih harmful effecs on US and possibly global growh. They run a US fiscal consolidaion scenario where he governmen deb-o-gdp raio is reduced by 60%-poins in he long-run by increasing axes by 3 per cen of GDP over 15 years. Their resuls sugges ha exensive and credible fiscal consolidaion could have large and durable benefis by reducing he curren accoun imbalance. In addiion, hey find ha he more flexible exchange raes in emerging Asian counries could help o amplify he effecs of US fiscal consolidaion on he US curren accoun defici. Furhermore, hey find ha more compeiion-friendly policies in Japan and he euro area could improve he US curren accoun balance by %-poin. In his paper, we examine wha facors could rigger he adjusmen and wha kinds of pahs of adjusmen hese imply using an exended version of he Euro area Dynamic General Equilibrium (EDGE) model developed a he Bank of Finland. EDGE model is a New Keynesian DGE model in which boh households and firms make opimising decisions. This model is appended wih new open economy feaures and is currenly a wo counry model. As wealh accumulaion is always aken ino accoun in he model, we consider his ype of model o be an ideal ool o analyse adjusmen of he US curren accoun defici. In maching he model o daa, we apply calibraion echniques o fix a number of he parameers in he model. We proceed wih Bayesian esimaion of he shock processes and heir persisence as well as he coefficiens of policy rules and adjusmen cos parameers. Bayesian esimaion has been recenly applied in he one counry case by Smes and Wouers (2003), Juillard e al (2004) and Adolfson e al (2005) and in he wo counry case by de Walque e al (2005) and Rabanal and Tuese (2005). Afer esimaion of parameers, we compare he momens of he model o he daa. In general, i is difficul o fi he model o daa. We neverheless ge a reasonable fi, a leas for he sandard deviaions of mos of he variables. However, he model seems o have rouble producing some of he cross correlaions in daa. In he following analysis, we uilise he esimaed wo counry EDGE model 1 o sudy he dynamic adjusmen of he US curren accoun defici. We assume 1 The simulaion properies of he model (in single counry, small open economy version) are repored in Tarkka and Korelainen (2001) and Korelainen (2002). 8

11 ha half of he prevailing curren accoun defici is unsusainable and ask wha facors could generae he necessary adjusmen of he US curren accoun o his susainable level. 2 Here, we focus on four differen mechanisms: increased savings by US households, a bigger dollar risk premium for inernaional invesors, an uncoordinaed fiscal policy ighening in he Unied Saes, and a coordinaed fiscal policy ighening in he Unied Saes and simulaneous fiscal policy loosening in he res of he world. We find ha if he adjusmen happens hrough increased savings by US households, adjusmen of defici is quie abrup. In he medium run, US consumpion decreases considerably. On he oher hand, US invesmen and expors increase, which booss US oupu. Inflaion decreases considerably, and he zero bound of nominal ineres rae could become a binding consrain. In he res of he world, boh invesmen and consumpion increase. The shock is calibraed o halve he US curren accoun defici, and he real effecive dollar exchange rae weakens by over 20% in he firs hree years. If he financial markes rigger he adjusmen by increasing he dollar risk premium, his adjusmen is less painful for US consumers. However, in his scenario he res of he world inflaion decreases subsanially, and he zero bound of nominal ineres rae could become a binding consrain for he res of he world. As a hird alernaive, we assume ha US fiscal policy is ighened in an uncoordinaed fashion. This reduces he US curren accoun defici bu is clearly no sufficien o induce he needed adjusmen. As a fourh alernaive, we assume ha boh he US and he res of he world use heir fiscal policies in a coordinaed way. In he Unied Saes fiscal policy is ighened while in he res of he world i is loosened. This is no srong enough o halve he prevailing US curren accoun deficis. However, neiher uncoordinaed nor coordinaed fiscal policy will push he nominal ineres raes close o zero bound, and he effecs on privae consumpion are a leas in he coordinaed case relaively moderae. Finally, he changes in he US and res of he world privae consumpion are smaller in he coordinaed case han in he uncoordinaed US fiscal policy case. In realiy, he world economy includes economic regions oher han he Unied Saes and he euro area and herefore he calculaions based on he esimaed model are merely indicaive. One source of imprecision is ha he weigh given o he US economy in he model is greaer han is acual weigh in he world economy. The calculaions based on hese esimaion resuls neverheless illusrae he effecs of US economic adjusmen on he res of he world economy. 2 In various sudies, he susainable level of US curren accoun defici is esimaed o be beween zero and four per cen of GDP (see Obsfeld and Rogoff 2004, Holman 2001 and Faruqee el al 2005). 9

12 All in all, he analysis suggess ha perhaps several differen shocks impacing hrough several differen channels would be needed in order o bring abou he needed curren accoun adjusmen. Moreover, hese shocks would have o be much bigger and more persisen han hose found in he daa. In addiion, he need for he adjusmen lies no solely wih he Unied Saes bu also wih he res of he world. The res of his paper is organised as follows. In secion 2 we explain he workings of he dynamic general equilibrium model used in he analysis. In he nex secion, we esimae he model, and in secion 4 we analyse he adjusmen of he US curren accoun defici. In he final secion, we draw some conclusions. 2 Model 2.1 Households Households are reaed according o Blanchard s sochasic lifeime model wih endogenous labour supply. Consumpion is derived from he household maximisaion problem wih no liquidiy consrains, habi persisence or oher forms of myopic behaviour. The insananeous uiliy funcion is addiively separable in consumpion and leisure 1- p max E [ logcs, + νlog( 1+ ns, )] (2.1) k = 0 1+ θ where E, c s,, n s,, ν, θ, and p are respecively he expecaions operaor condiional on informaion a ime, he period consumpion of a cohor born a ime s, he period labour supply of a cohor born a ime s, he weigh of disuiliy of providing labour supply, he rae of ime preference, and he consan probabiliy of dying. The sochasic variaion in he rae of ime preference is assumed o follow an AR(1) process as in Levin e al (2005). The periodic budge consrain 1+ z 1 is w s, = w s, 1 + ys, cs,, where w s,, y s,, and z -1 are he period wealh 1 p and labour income of an agen born a ime s, and he expeced reurn on wealh. The opimal consumpion plan is obained by maximising above subjec o he lifeime budge consrain. This yields he firs-order condiions, which are hen subsiued back ino he lifeime budge consrain o yield he consumpion funcion for each household. Aggregaing as in Black e al (1994), enables us o wrie he aggregae consumpion funcion as 10

13 1 1 1 EC = Λ 1 ( ) p + Λ E 1 z Λ 1 p + 1 p {( 1+ z ) Ψ YD } C + (2.2) where Λ = 1 (1 p)/(1+θ) is he marginal propensiy o consume. C, Ψ, YD = z 1 Ψ 1 + Y, and Y are respecively aggregae consumpion, aggregae wealh, privae disposable income, and oupu. We define aggregae wealh as he accumulaed ne presen value of capial income P C Ψ E = + C ( P Ψ NFA G ) ( 1+ R / 400)( 1+ χ) Y I [( 1 τ ) P Y WL δp K 1] + NFA + G (2.3) where C P, Y τ, P, W, L, NFA, G, R, δ, I P, K, and χ are consumpion deflaor, indirec ax rae, oupu deflaor, nominal wage rae, labour, ne foreign asses, governmen deb, nominal ineres rae, depreciaion rae, invesmen deflaor, capial sock and he equiy premium. We furher define privae nominal disposable income as P C YD = + Y ( 1 τ ) P Y τ W R 1 WL + G I ( ω1u + ω2 ) P Y + NFN b4p Y δp K 1 (2.4) W where τ, NFN, and U are direc ax on wages, he ne facor income on ne foreign asses, and unemploymen. ω 1, ω 2, and b 4 are parameers. On he righ hand side are we have he value of oupu afer indirec axes, income axes, ineres income, ransfers from governmen, income from ne foreign asses, share of capial income paid o he governmen, and finally depreciaion. The aggregae labour supply is obained by aggregaing he corresponding firs order condiion F C = N ν (2.5) W W ( 1 τ ) P where F and N are he oal labour force and oal populaion. Blanchard s model inroduces finie lifeimes for households, which affecs he relevan discoun rae. The marke rae of ineres ha he governmen pays on is deb is differen from his. The difference resuls in failure of Ricardian equivalence. I is furher assumed ha income axes are disorionary, which creaes a ax wedge and affecs he labour supply decision. This creaes an 11

14 addiional non-ricardian channel. Blanchard s model also provides a well-defined seady-sae for inernaional asse posiions. Households se new nominal wage conracs a sochasic inervals à la Calvo. Those households ha can no se new wages are able o adjus heir wages o he pace of pas inflaion, ie dynamic indexaion applies. Thus, he firms minimise following loss funcion 2 j 1 j j W new ( 1 w ) E Wi, W j 2 ρ φ j 0 W (2.6) 1 + = new where ρ, φ W, W i,, W, and W are he discoun facor, he Calvo probabiliy of making new conracs, he new nominal wage conrac, observed nominal wage rae, and opimal wage. The opimal wage equals he marginal produc of labour. 2.2 Firms There are several ypes of firms in he economy. In modelling he final goods secor we follow Laxon and Peseni (2003). Final goods firms combine boh domesic value added goods and impored goods wih consan-elasiciy-ofsubsiuion echnology o produce privae consumpion goods, public consumpion goods, invesmen goods and expor goods. An example of he producion funcion for privae consumpion goods is C c h ( x) θ γ Y ( x) 1 C [ ] θ f C + ( 1 γ ) θc [ Y ( x) ] C 1 θ θc θ a C = c (2.7) where x is he domesic final goods firm. Inermediae goods are produced by firms h (domesic) and f (foreign). γ C ( 0,1) is he weigh of local value added inpus in he producion of final consumpion. θ C is he elasiciy of subsiuion beween domesic value added goods and impored inpus. The minimum cos of C 1 θ M 1 producing one uni of C is hus P γ [ P ] + ( 1 γ )[ P ] 1 θ C C 1 θc ( C C ) =, where P and P are he prices of domesic value added goods and impors. The expor and M invesmen price deflaors are derived similarly. The inermediae firms combine labour and capial wih Cobb-Douglas echnology o produce value added goods 12

15 h ( ) α h h 1 K ( η A L ) α h Y = (2.8) where h Y, A, h K, h L, α, and h A are oupu, capial sock, labour inpu, capial share of income, and he labour-augmening (Harrod-neural) level of echnology in domesic inermediae goods firm h. The sochasic produciviy shock, η A,, is assumed o follow an AR(1) process common o all inermediae goods firms. Invenory managemen firms minimise coss arising from he imbalance beween realised producion and he normal level of producion implied by he Cobb-Douglas producion funcion and he deviaions of invenories from some exogenous reserve level 1 E 2 j= 0 j ρ φ KI 2 h h h h ( KI j KI + j) + ( Y + j Y + j) 2 + (2.9) where φ KI, KI, and KI are he adjusmen cos parameer, invenories, and he exogenous reserve level. The facor demands are modelled via capial and labour service firms. The capial service firms maximise he discouned presen value of real dividends h h h h h h [ p F( K,L ) Γ( K,K,K ) I ] j ρ + j + j + j + j 1+ j 2+ j + j E (2.10) h h h subjec o he capial accumulaion equaion K = I + ( 1 δ) K 1, where I is I invesmen, ρ is he discoun facor and p = P / P. These firms face a ranslog adjusmen cos funcion describing how coss arise in changing capial and h h h h h 2 h invesmen: F( K,K 1,K 2 ) = φk ( ΔK φδ KΔK 1) /( 2K 1), where φ K and φ ΔK are adjusmen cos parameers. Labour services are provided by a firm ha minimises a Roembergian adjusmen cos funcion. The represenaive labour service firm minimises a loss funcion for changes in labour and deviaions of labour inpu from he opimal amoun. Opimal level of labour demand is defined by invering he Cobb- Douglas producion funcion. The firms minimise following loss-funcion 1 E 2 j= 0 ρ 2 2 [( Li, + j Li, + j 1) + φl( Li, + j L + j) ] j (2.11) where ρ is he discoun facor and φ L is he adjusmen cos parameer. Furhermore, we assume ha he prices of inermediae goods are defined by Calvo conracs. As wih wage deerminaion, inermediae firms ha canno 13

16 change prices are neverheless able o adjus heir prices o he pace of pas inflaion, ie dynamic indexaion applies. The firms minimises 1 2 j= 0 ( 1 φ ) P j 2 j j i, ρ P E Pi, P + j (2.12) P i, 1 where φ P is he Calvo probabiliy ha he firm will change prices. In he long run, prices equal marginal coss. 2.3 Governmen The governmen secor does no opimise explicily. I is characerised by he governmen budge consrain and wo policy rules: he budge closure rule of he fiscal auhoriy and he moneary policy rule of he moneary auhoriy. Governmen budge consrain is defined as ( G G ) 1 = τ W W L + τ P Y + b P Y Y 4 R 400 I 1 ( b1 + ηcg, ) P Y + b2p Y + ( ω1u + ω2 ) P Y + G 1 (2.13) where η CG, is he governmen expendiure shock and b 1, b 2, ω 1, ω 2, and b 4 are parameers. The lef hand side is governmen ne lending. The righ hand side comprises governmen income (direc and indirec axes, capial income) and governmen oulays (governmen consumpion, invesmen, ransfers and ineres oulays). We assume ha he governmen consumpion shock is sochasic and follows an AR(1) process. The fiscal policy rule is imposed o guaranee ha he dynamic budge consrain is binding. The income ax rule assumes ha he governmen balances is budge in he long run hrough ax changes. As arge variables in his fiscal rule boh he deb-o-gdp and budge defici-o-gdp raios are applied 14 ( 1+ g)( 1+ π) 1 ( 1+ g)( 1+ π) W W G G G 1 τ τ 1 = τ1 4b4 τ2 + 4b3 (2.14) P Y P Y where τ is he coefficien of deviaions from he argeed deb level and τ 2 is he coefficien of deviaions of ne lending from argeed ne lending. b 3, g and π are he deb-o-gdp arge, real growh rae, and he inflaion arge. The moneary policy rule is used o pin down he growh rae of he undeermined price level. A Taylor-rule ype of moneary policy rule is applied

17 R 400 R 1 = λ1 + ( 1 λ1) [(( 1+ π )( 1+ r) 1) + λ2( π π) + λ3( y y) ] + ηr, (2.15) 400 where r, λ 1, λ 2, and λ 3 are respecively he real ineres rae, smoohing parameer, weigh of he inflaion gap, and weigh of he oupu gap respecively. η R, is he ineres rae shock, which follows an AR(1) process. y = logy and y is he log of seady-sae oupu. The cenral bank provides an anchor for inflaion expecaions by seing an explici inflaion arge π. The moneary policy rule is a varian of he Taylor -rule (see Taylor 1993). 2.4 Foreign counry The counry blocks (home and foreign) are isomorphic. Trade linkages are used o connec he counry blocks, o ha he curren accoun balance is defined as X M X M CA = P X P M + NFN, where P, X, P, M, and NFN are expor prices, expors, impor prices, impors, and ne facor income from ne foreign asses. The R 1 laer is defined as NFN = 1 + NFA 1 400, where he inernaional facor incomes are modelled as ineres on USD -denominaed shor-erm deb. In a closed world economy, he domesic and foreign ne facor incomes of ne foreign asses sum o zero. Thus, he foreign ne facor income is defined as NFN = NFNS. In addiion, he ne foreign asses of he home counry are accumulaed from he curren accoun posiions: NFA = NFA 1 + CA. Foreign ne foreign asses are defined as NFA = NFAS. Moreover, we assume ha he nominal exchange rae is deermined by he uncovered ineres rae pariy R R arbirage condiion: logs = loges ηs,, where S is he foreign 400 currency price of home currency and η s, is a shock o he exchange rae premium, which is assumed o follow an AR(1) process. 2.5 Equilibrium In a compeiive equilibrium, households maximise heir uiliy subjec o he budge consrain, and firms maximise heir profis subjec o echnological feasibiliy. In addiion, all markes clear. Finally, all prices are zero for goods in excess supply. 15

18 3 Maching model o daa 3.1 Daa The euro area (EA) daa is from Eurosa, ECB, OECD and IMF. Mos of he EA series are unforunaely very shor, saring from Therefore, we exended he hisorical daa by chaining i wih he AWM daabase (see Fagan e al, 2001). The US daa is from he Bureau of Economic Analysis, Bureau of Labor Saisics, OECD and IMF. Using hese daa sources, we buil a daabase covering 1977q1 o 2004q4. Our model is a closed economy wo counry model, and he acual daa includes EA, US and implicily a hird counry (res of he world). To cope wih his discrepancy beween model and daa we adjus he observed daa o mach he model. We do his by firs redefining he US expors and impors so ha hese mach corresponding EA figures (adjused wih he exchange rae). To balance he GDP ideniy we recalculae US invenories as a residual. In a similar way we use he EA curren accoun, ne facor incomes and ne foreign asses daa o replace corresponding US daa. We esimae he model in wo seps. Firs, we calibrae he srucural parameers o be broadly in line wih he exising lieraure. Second, we esimae he adjusmen cos parameers, policy parameers and shock dynamics of he model. In his laer sep, we uilise Bayesian esimaion echniques. 3.2 Calibraion Calibraed parameers are shown in Table 1 below. Almos all variables are calibraed symmerically. The capial share of income is ypically found o be around In calculaing he raio of nominal compensaion o nominal GDP a facor cos we find ha boh he US capial share and he EA capial share are close o 0.4 on average in The quarerly depreciaion rae is assumed o be around in he lieraure (see Cooley 1995, Smes and Wouers 2003, Juillard e al, 2004 and Adolfson e al, 2005). We assume ha he depreciaion rae is symmerically 10% per annum. Wih his depreciaion rae, half of he new capial is depreciaed in abou seven years. Siegel (1992) finds ha he equiy premium in US daa for he years is roughly 3% p.a. We calibrae he equiy premium o be symmerically 4.9% per annum. 16

19 Table 1. Calibraed parameers EA US Capial share of income α Quarerly depreciaion rae δ Quarerly equiy premium χ Quarerly moraliy rae p 1/80 1/80 Quarerly birh rae b 1/75 1/75 Quarerly growh rae of oal facor produciviy ε Quarerly rae of ime preference θ Quarerly inflaion arge π Disuiliy of labour effor ν Targeed invenories/oupu K Share of domesic value added goods in privae consumpion γ C Share of domesic value added goods in gov consumpion γ CG Share of domesic value added goods in invesmen γ Share of domesic value added goods in expors γ X Subs.elas.(value added vs. impors) in privae consumpion θ C Subs.elas.(value added vs. impors) in gov consumpion θ CG Subs.elas.(value added vs. impors) in invesmen θ Subs.elas.(value added vs. impors) in expors θ X Seady-sae governmen real consumpion o GDP raio b Seady-sae governmen nominal invesmens o GDP raio b Seady-sae governmen deb o GDP raio b Seady-sae governmen oher income o GDP raio b Seady-sae governmen ransfers elasiciy o unempl ω Seady-sae level of governmen ransfers ω Indirec ax rae τ Y NAIRU U Equilibrium real ineres rae r The moraliy rae is calibraed o give a remaining average lifeime of 20 years. The birh rae is calibraed so ha he annual populaion growh rae is 0.27%. The annual growh rae of oal facor produciviy is 1.7 per cen and hus he annual growh rae of he economy is roughly 2%. The rae of ime preference is 2.8% in annual erms. Wih his rae of ime preference, we see ha he real ineres rae on governmen deb in equilibrium is higher han he real growh rae. We also find ha he sum of he pure rae of ime preference and he probabiliy of deah exceeds he real rae of ineres rae in he seady-sae. The inflaion arge is calibraed symmerically o 2% per annum. Currenly for EA arge of inflaion rae is less han 2% while for US here is no explici inflaion arge. The disuiliy of labour is calibraed symmerically o This and oher parameers in seady-sae imply ha he Frisch elasiciy (elasiciy of labour supply wih respec o real wage) is close o 0.33 for EA and USA. These Frisch elasiciies are close o hose found in micro sudies, which range from , and o he 0.33 used by Juillard e al (2004). The RBC lieraure, on he oher 17

20 hand, has found higher Frisch elasiciies. The argeed invenories-o-oupu raio is se symmerically o 0.5. The share of value added goods in final goods producion is calibraed roughly in line wih he daa. Erceg e al (2005b) find ha he average share of impors in US consumpion (invesmen) is around 9 (38) per cen. We calibrae he impor share of consumpion (boh public and privae) o be 10%. The impor share of invesmen is se o 15%. Finally, we se he impor share of expors o 25%. The subsiuion elasiciies beween he value added goods and impors in final goods producion is se o 1.5 for all final goods firms. This is a he lower end of esimaes used in NOEM models, which generally range beween 1.5 and 6 (see Bayoumi e al, 2004, Erceg e al, 2005b and Obsfeld and Rogoff, 2004). However, Bergin (2004) finds evidence of a uniary long-run elasiciy. The seady-sae raios of governmen variables are se o levels of las observaion in he daa. 3.3 Esimaion We esimae he adjusmen cos parameers, policy parameers, and shock dynamics of he model by Bayesian mehods. We assume ha here are 9 srucural shocks in he wo counry model. For he EA we assume ha here are produciviy, governmen absorpion, ineres rae and preference shocks. Similar shocks hi he US economy. Finally, we allow an exchange rae risk premium shock. The laer may no have profound economic inerpreaion, as noed by Rabanal and Tuese (2005). However, we find i useful o include his shock o generae more variaion in he real exchange rae. In esimaion, we allow he shocks o be auoregressive processes. Wih hese nine shocks we explain nine observed variables: EA oupu, EA consumpion, EA inflaion, EA ineres rae, US oupu, US consumpion, US inflaion, US ineres rae, and he real exchange rae. The model variables are measured in efficiency unis, eg oupu is divided by boh populaion and he level of echnology. The relaive growh rae is used when we express expors in efficiency unis. We wrie a dynamic equaion for he relaive growh rae ha generaes an addiional uni roo in he model. We ake his ino accoun in esimaion by using diffuse priors. Saionarisaion may leave some variables wih rending behaviour in our sample. Specifically, boh EA oupu and US oupu in efficiency unis are increasing slighly in 1977q1 2004q4. Thus, we prefiler he observed variables by Hodrick-Presco wih a smoohing parameer value of 10,000. This prefilering removes he long-run rends from our daa. In order o esimae he model we assume cerain prior disribuions, which are based on our previous calibraion exercises and exising lieraure. We 18

21 esimae he model in wo seps in Dynare/Malab, as in Juillard e al (2004). In he firs sep, we compue he poserior mode using he CSMINWEL opimisaion rouine by Sims. We hen sample he poserior disribuion using a Meropolis- Hasings Markov chain Mone Carlo algorihm o make sample inferences abou he parameers. We sampled wo separae chains for 40,000 periods, discarding he firs 10,000. In order o assess convergence of he Markov chains, we use he poenial scale reducion saisics described by Brooks and Gelman (1998). The mulivariae saisics indicae ha he parameers do convergence. The las wo columns in Table 2 repor he poserior means of he parameers and he 90% confidence inervals. We assume ha our priors for he sandard errors of he sochasic processes have invered gamma disribuions. The priors of all oher parameers have bea disribuions. An excepion is he level parameer in capial adjusmen cos, which is only consrained from below and so we use a gamma disribuion for i. The mean of he priors is se mainly according o our previous calibraion exercises as well as he exising lieraure. We se a relaively srong prior for he level of capial adjusmen cos. This is also se asymmerically. We do his in order o invoke enough invesmen variaion. Anoher asymmery lies in nominal rigidiies, which we assume o be more relaxed for he US. The esimaed poserior sandard errors for preference and exchange rae risk premium shocks are lower han he priors. The poserior means of sandard errors for ineres raes are well above he priors. The sochasic processes exhibiing he mos persisence are he produciviy, governmen consumpion, and exchange rae risk premium shocks. The persisence of preference shocks, and especially moneary policy shocks, is low. 19

22 Table 2. Esimaed parameers Prior Poserior disribuion mean Sd mean 90% inerval Risk premium shock ε S inv.gamma EA EA produciviy shock ε A inv.gamma US US produciviy shock ε A inv.gamma EA EA gov spending shock ε A inv.gamma US US gov spending shock ε A inv.gamma EA EA ineres rae shock ε A inv.gamma US US ineres rae shock ε A inv.gamma EA EA preference shock ε A inv.gamma US US preference shock ε A inv.gamma AR(1) in risk premium ρ bea AR(1) in EA produciviy AR(1) in US produciviy AR(1) in EA gov spend AR(1) in US gov spend AR(1) in EA in rae AR(1) in US in rae AR(1) in EA preference AR(1) in US preference EA Calvo price S EA ρ S bea US ρ S bea EA ρ S bea US ρ S bea EA ρ S bea US ρ S bea EA ρ S bea US ρ S bea φ bea p US Calvo price φ P bea EA Calvo wage φ W bea US Calvo wage φ W bea EA labour adj cos φ L bea US labour adj cos φ L bea EA lev in capi.adj cos φ K gamma US lev in capi.adj cos φ gamma EA EA chg capi.adj cos φ ΔK bea US US chg in capi.adj cos φ ΔK bea EA EA inven. adj cos φ KI bea US inven. adj cos φ bea US KI 20

23 Prior Poserior disribuion mean Sd mean 90% inerval EA Taylor smoohing λ 1 bea EA Taylor infl gap λ 2 bea EA Taylor oupu gap λ 3 bea US Taylor smoohing λ 1 bea US Taylor infl gap λ 2 bea US Taylor oupu gap λ 3 bea EA deb in ax rule τ 1 bea EA defici in ax rule τ 2 bea US deb in ax rule τ 1 bea US defici in ax rule τ 2 bea Bils and Klenow (2004) find frequen price changes in US daa wih half of he prices holding for less han 4.3 monhs. Álvarez e al (2005) find he corresponding median duraion in price changes o be 10.6 monhs for he euro area. The poserior mean esimaes are 0.37 for he EA and 0.52 for he US. These indicae ha prices are changed approximaely each 2.7 quarers in EA and each 1.9 quarers in US. These esimaes are close o he microeconomic evidence found for EA and US. Wih respec o nominal ineria in wages, he poserior mean esimae of he Calvo wage parameer for EA is 0.18, bu for US he poserior mean is These esimaes could be inerpreed so ha wages are se in every 5.5 quarers in EA and in every 3 quarers in US. In addiion, we noice ha he poserior mean for wage adjusmens is lower han he price adjusmen, suggesing ha prices are adjused more frequenly han wages. The poserior esimaes for labour adjusmen are higher han he priors and he US labour adjusmen coss are much higher. The lower he labour adjusmen cos parameer, he higher he coss of hiring and firing relaive o he coss of labour deviaing from he opimal level. This could be inerpreed o mean ha he hiring and firing coss are higher in EA han in US. The poserior esimaes of invenory coss are close o he priors and neiher show any clear asymmery. The esimaed poserior means of he parameers of he level of capial adjusmen cos increase slighly in comparison o priors for boh counries, despie he fac ha we effecively nailed hem down. The poseriors of he parameers of he change in capial adjusmen coss are somewha lower han he priors and he US coss seem o be somewha lower han EA coss. In he Taylor rule, he priors of parameers for inflaion gap and oupu gap are se o 0.5, as conjuncured by Taylor (1993). The esimaed poseriors indicae ha European moneary policy during he period enails more ineres rae smoohing and reacs more sharply o inflaion han US moneary policy. In he fiscal rule, he poserior mean esimaes indicae ha European fiscal policy over 21

24 he period reacs more sharply o defici and less sharply o deb han he US fiscal policy. 3.4 Validaion In assessing he esimaion of he model we consider how well he model fis he daa. The sylized facs of he daa and similar saisics for 50,000 sochasic model simulaions (of which we discard he firs 1,000) are presened in Table 3. Table 3. Observed and implied second momens Daa Model Saisic US EA US EA Sandard deviaions GDP Consumpion Invesmen Employmen Ne rade Real exchange rae Auocorrelaions GDP Consumpion Invesmen Employmen Ne rade Real exchange rae Cross correlaions over counries GDP Consumpion Invesmen Employmen Cross correlaions wihin counries GDP Real exchange rae Consumpion Real exchange rae Invesmen Real exchange rae Ne rade Real exchange rae Relaive consumpion Real exchange rae Relaive GDP Real exchange rae The resuls indicae ha our model is able o replicae reasonably he sandard deviaions and auocorrelaions observed in he daa. Wih respec o crosscorrelaion srucure, our model is a odds wih he daa. Neverheless, his consrained se of srucural shocks is able o produce momens which a leas broadly agree wih he daa. 22

25 Wih a closer look, we find ha he sandard deviaions of EA consumpion and GDP are clearly higher han in he daa. The model's sandard deviaions of employmen, ne rade and real exchange rae are less han hose observed in he daa. Also, he auocorrelaion coefficiens produced by he model are somewha low compared o he daa. Cross correlaions over counries are small and clearly a odds wih daa, as also in de Walque e al (2005). This suggess ha he assumed rade linkages in he model are no sufficien o produce he observed cross correlaion srucure. A second area of ineres concerns he degrees of independence of he sochasic processes. In he esimaion process we assume ha he shocks are i.i.d. We repor he correlaion srucure of some shocks in Table 4. Alhough correlaion does no necessarily imply dependence, we find ha he null of zero correlaion coefficien is rejeced for he conemporaneous governmen spending shocks. Also, he conemporaneous ineres rae shocks are significanly correlaed. Table 4. Correlaion beween innovaions over he wo economies US EA conemporaneous EA US The variance decomposiion of he observed variables is shown in Table 5. We find no ineresing spillovers across counries. The US shocks do no maer much for he EA economy and vice versa. This resul is similar o ha of de Walque e al (2005). Table 5. Variance decomposiion Y EA C EA π EA R EA Y US C US π US R US Q EA produciviy shock EA preference shock EA gov.spending shock EA ineres rae shock EA shocks US produciviy shock US preference shock US gov.spending shock US ineres rae shock US shocks Risk premium shock Y, C, π, R and Q denoe o oupu, consumpion, inflaion, ineres and real exchange rae. 23

26 For boh counries i seems ha domesic produciviy shocks are he mos impor source of variaion in inflaion. The second imporan source of variaion in inflaion is exchange rae risk premium shocks. Also, he domesic fiscal policies do maer, bu heir imporance is of a second order. Regarding he variabiliy in nominal ineres raes, we find ha all domesic shocks maer, bu exchange rae shocks have huge impacs on he variaion. The variabiliy in oupu sems mosly from he domesic governmen spending shocks. The risk premium and produciviy shocks are also imporan sources of oupu variaion. Consumpion variaion is affeced by facors similar o hose for oupu. 3.5 Impulse response funcions Impulse responses for one sandard deviaion shocks are shown in Figure 1. In his figure we show how US specific shocks as well as he exchange rae risk premium shocks are ransmied. EA specific shocks look almos idenical o US specific shocks and so we examine only US shocks. Figure 1. Impulse response funcions (% from baseline, %-poin for inflaion and ineres rae) 24

27 US specific shocks do no seem o affec he EA economy. Only he exchange rae risk premium shock has considerable effecs on boh counries. The oupu reacion of he esimaed produciviy shock is almos four imes as big as in eg Juillard e al (2004). Excep for he size, he only noable difference from he resuls of Juillard e al (2004) is ha here labour supply reacs posiively o he produciviy shock. Erceg e al (2005b) repor a produciviy shock wih he same profile, bu heir exercise is much more persisen and hus he reacion lass for several years. The resuls of he preference shock are close o he esimaed policy version of Levin e al (2005). Employmen declines as do he labour hours in Levin e al (2005). Consumpion increases immediaely, since we assume no habi behaviour. Inflaion increases in he shor run, bu he shor-run increase in he nominal ineres rae is much more moderae han in Levin e al (2005). Levin e al (2005) and Juillard e al (2004) repor a very similar profile of heir resuls for an expansionary governmen spending shock, bu he effecs are somewha smaller han here. Erceg e al (2005b), on he oher hand, apply an even bigger governmen spending shock han esimaed here. The oupu reacion of conracionary moneary policy shock is beween he resuls of Chrisiano e al (2005) and Juillard e al (2004) or Erceg e al (2005b). US GDP inflaion acually increases in he shor-run before dropping from he baseline level. The US consumer price inflaion ha he cenral bank is argeing follows GDP inflaion bu reacs more rapidly o ighening of he policy. Mos of he resuls of he moneary policy shock are in line wih he findings of Juillard e al (2004). The effecs of he rise in dollar risk premium may be compared o he exercise of Erceg e al (2005b). The oupu, inflaion and domesic absorpion reacions are closely aligned wih hose of Erceg e al (2005b). 4 Adjusmen of he US curren accoun defici In analysing he adjusmen of he US curren accoun defici we uilise he wo counry model developed and esimaed above. We apply he model as if i describes he Unied Saes and he res of he world. For he sake of argumen le us assume ha he Unied Saes presen 6.6% curren accoun defici is approximaely wice as big as he susainable defici. In oher words, a leas half he presen defici is emporary. Nex, we can ask wha processes could bring he defici down o a susainable level. As here are numerous possible channels ha could lead o adjusmen, i is imporan o consider wheher he differen processes would lead o radically differen pahs of adjusmen. 25

28 Among oher facors, he speed and form of he adjusmen process will depend on he response of moneary policy. In such calculaions, i is impossible o avoid making simple and fairly mechanical assumpions as o how moneary policy responds o changes in he economy. In he presen calculaion we assume ha he policy ineres rae (shor-erm money marke rae) responds boh in he Unied Saes and in he res of he world according o he Taylor rule. This rule, which is widely used nowadays in applied economic analysis o describe he normal response of moneary policy, assumes ha ineres raes are deermined by how far he pace of inflaion differs from he arge (here assumed o be 2%) and how wide is he oupu gap. Including he oupu gap in he moneary-policy decision rule moderaes ineres rae movemens and inroduces a forward-looking elemen o he seing of ineres raes, because demand pressure on he commodiy and labour markes is one of he facors influencing fuure inflaion. Here, we examine more closely four differen ypes of change ha could cause he US curren accoun defici o adjus owards a susainable level. These are (a) an increase in he level of household savings in he Unied Saes, (b) an increase in dollar risk premium, (c) an uncoordinaed fiscal policy ighening in he Unied Saes, and (d) a coordinaed fiscal policy ighening in he Unied Saes and simulaneous fiscal policy loosening in he res of he world. In our calculaions, hese changes are implemened on such a large scale as o have a subsanial effec on he US curren accoun defici. 4.1 An increase in US household savings In he firs calculaion we assume ha he US households become more worried abou heir fuure. This would lead hem o increase heir level of saving. In he model calculaion his is aken ino accoun by lowering households ime preference rae by 1.8 percenage poins per annum over he nex hiry years. This has a direc impac on how US households in he model discoun heir fuure income and consumpion. According o he resuls of his calculaion, an increase of 10 percenage poins in he US household saving raio would roughly halve he US curren accoun defici from is presen level (see Table 6). The adjusmen would also involve a lowering of US ineres raes. GDP would increase, as boh fixed invesmen and expors increase, compensaing for he conracion in consumer demand. There would also be a marked deceleraion in inflaion in he medium erm, which jusifies he decline in ineres raes. However, he fall in inflaion is so pronounced ha i pushes US nominal ineres raes close o he zero bound. As a consequence of his savings driven adjusmen, here would be a lile if any change in GDP ouside he Unied Saes in he firs five years. There would 26

29 be a subsanial reducion in expors o he Unied Saes, bu a he same ime a marked increase in boh consumpion and fixed invesmen. This is a consequence of he srong downward rend in ineres raes associaed wih his paricular adjusmen alernaive. As he US curren accoun defici conracs, he curren accoun surplus of he res of he world would also conrac in andem. Under his scenario, he real effecive dollar exchange rae would weaken over 20% in he firs five years. 4.2 An increase in dollar risk premium In he second calculaion, we assume a receding willingness on he par of inernaional invesors o hold American asses. Technically his calculaion was carried ou by gradually raising he risk premium on dollar invesmens required by inernaional invesors o 0.5% on average for he nex en years. According o he resuls of his calculaion, he effecive dollar exchange rae weakens by over 20% nominally and by over 15% in real erms in he firs hree years (see Table 6). The US curren accoun defici relaive o GDP would conrac by 3 percenage poins, ie by almos half. This calculaion also produces a vigorous increase in he American household saving raio and a corresponding drop in privae consumpion. Rising ineres raes, a direc consequence of he higher risk premium on he dollar, also means a decrease in fixed invesmens in he Unied Saes. The weakening dollar spurs ne expors, which in urn boos US GDP, bu only slighly. By reducing domesic demand, he rise in ineres raes faciliaes adjusmen of he curren accoun defici. In conras o he previous calculaion, his alernaive has a considerable negaive impac on inflaion in he res of he world. Hence he ineres rae response is also sizeable. The dramaic weakening of he dollar raises impor prices in he Unied Saes and, by exension, inflaion, despie he rise in ineres raes. A he same ime, impor prices in he res of he world fall, reducing inflaion o he same exen as he increase in he Unied Saes. If he dollar decline were o occur a once, as we assumed here, he fall in inflaion in he res of he world would be so seep ha i would probably lead o deflaion. The fall in ineres raes produced by his model is so large ha ouside he Unied Saes a zero nominal ineres rae floor could become a binding consrain. GDP in he res of he world increases only slighly in his calculaion, as he increase in consumpion and invesmen compensaes for he conracion in ne expors. From economic policy perspecive, however, he picure is no quie so favourable, since he world ouside he Unied Saes ends up wih deflaion and a binding zero ineres rae floor. 27

30 Table 6. Dynamic adjusmen of he US curren accoun defici US household saving raio increases Dollar risk premium increases Uncoordinaed US fiscal ighening Coordinaed fiscal policy 1Y 3Y 5Y 1Y 3Y 5Y 1Y 3Y 5Y 1Y 3Y 5Y Unied Saes Curren accoun, % of GDP GDP, % Privae consumpion, % Privae fixed invesmen, % Household savings raio, %-poin Inflaion (GDP deflaor), %-poin Nominal ineres rae, %-poin Real effecive exchange rae, % Nominal effec. exchange rae, % Res of he world Curren accoun, % of GDP GDP, % Privae consumpion, % Privae fixed invesmen, % Household savings raio, %-poin Inflaion (GDP deflaor), %-poin Nominal ineres rae, %-poin Uncoordinaed fiscal policy In he hird calculaion, we assume ha US fiscal policy is ighened in an uncoordinaed fashion. Technically, we reduce US public consumpion by one percenage poin of GDP for fifeen years. Taking accoun of he esimaed persisence of US public consumpion shocks he effecive decrease in public consumpion is approximaely 4%-poins per annum for fifeen years. In addiion, we suppress he fiscal rule for fifeen years, so ha fiscal savings improve he fiscal balance by approximaely 4 percenage poins per annum. We assume furher ha he fiscal savings are fully used o reduce he US governmen deb. Thus, he US governmen deb-o-gdp raio decreases by 60 percenage poins in fifeen years. Afer his, we allow he fiscal rule o work. According o he resuls of his calculaion, an uncoordinaed fiscal policy ighening in he Unied Saes improves he US curren accoun balance by roughly one percenage poin (see Table 6). As governmen expendiure is nonproducive in he model his reducion in governmen consumpion generaes a srong crowding in effec in US privae consumpion. Neverheless, oupu falls because he decrease in governmen consumpion is subsanial. The dollar depreciaes by abou 5% in real erms. The US nominal ineres rae and inflaion change very lile. In he res of he world boh consumpion and invesmen increase bu here is very lile effec on oupu. Inflaion and nominal ineres raes are almos 28