Fiscal Consolidation in an Open Economy

Transcription

1 Fiscal Consolidaion in an Open Economy Chrisopher J. Erceg Federal Reserve Board Jesper Lindé Federal Reserve Board and CEPR December 29, 2 Absrac This paper uses a New Keynesian small open economy model o examine how he effecs of fiscal consolidaion vary depending on wheher moneary policy is consrained by currency union membership vs. he zero bound on ineres raes. JEL Classificaion: E52, E58 Keywords: Moneary Policy, Currency Union, Fiscal Policy, Zero Lower Bound Consrain, New Keynesian open economy DSGE Model. The views expressed in his paper are solely he responsibiliy of he auhors and should no be inerpreed as reflecing he views of he Board of Governors of he Federal Reserve Sysem or of any oher person associaed wih he Federal Reserve Sysem. Corresponding Auhor: Telephone: Fax: addresses: chrisopher.erceg@frb.gov and jesper.l.linde@frb.gov

2 . Inroducion Given heighened concerns abou deb susainabiliy, many counries are implemening ambiious fiscal consolidaion plans in which governmen spending reducions ofen play a major role. The usual presumpion is ha he effecs of governmen spending cus on oupu are smaller when a counry conducs an independen moneary policy (IMP) han when consrained by membership in a currency union, reflecing ha ineres rae cus and currency depreciaion appear o significanly dampen he adverse impac on aggregae demand. While hisorical evidence from large-scale fiscal consolidaions episodes suppors his view (Alesina and Peroi, 997), i is unclear wheher an IMP reains is comparaive advanage if consrained by he zero lower bound, especially in ligh of closed economy analysis showing how a liquidiy rap can amplify he fiscal muliplier. This paper uses a New Keynesian DSGE model of a small open economy o examine condiions under which a persisen cu in governmen spending reduces oupu more under an IMP consrained by he zero lower bound han in a currency union (CU). Given ha adjusmen of he policy rae is precluded in boh moneary regimes for a leas some ime, he oupu effecs of fiscal conracion are larger han under an unconsrained IMP. Bu across he wo consrained regimes, he relaive magniude of he oupu conracion urns ou o be highly sensiive o srucural feaures which deermine how he real exchange rae and long-erm real ineres rae respond o fiscal consolidaion. If inflaion is fairly sensiive o he oupu gap (i.e., he Phillips Curve has subsanial upward slope), oupu conracs more deeply under an IMP han a CU if policy raes are consrained from adjusing for a susained period of roughly wo years or more. Imporanly, he anchoring of he nominal exchange rae in a CU urns ou o be a blessing insofar as i avoids he large appreciaion of he real exchange rae ha would occur in a persisen liquidiy rap, and implies a smaller rise (if any) in long-erm real ineres raes. By conras, if he Phillips Curve is very fla, he real exchange rae depreciaes even in a prolonged liquidiy rap and long-erm real ineres raes fall, so ha he oupu conracion under an IMP is smaller han under a CU; hus, he economy benefis from fron-loaded depreciaion, even if smaller han in he unconsrained case. We conclude by arguing ha recen episodes of large-scale fiscal consolidaions including in counries facing each form of moneary consrain should be highly informaive in discriminaing beween hese conrasing predicions of he heory. See papers by Eggerson (2), Woodford (2), and Chrisiano, Eichenbaum, and Rebelo (2).

3 2. A New Keynesian Open Economy Model Our benchmark model is very similar o he small open economy models of Clarida, Galí, and Gerler (2), and Galí and Monacelli (28). equaions are given by: Under an independen moneary policy, he key x = x + ˆσ open (i π + r po ), () π = βπ + + κ p x, (2) i = max ( i, γ π π + γ x x ), (3) y = ˆσ open τ + g y g + ( g y) )( ω)ν c ν (4) y po = φ mcˆσ [g yg + ( g y )( ω)ν c ν ] (5) τ po = ˆσ open ( φ mcˆσ open ) [g yg + ( g y )( ω)ν c ν ] (6) r po = τ po + τ po, (7) p = p + π, (8) where ˆσ open, κ p, and φ mc are composie parameers defined as: e = p + τ, (9) ˆσ open = ( g y )[( ν c )( ω) 2 σ + ω(2 ω)ε P ] () κ p = κ mc φ mc () φ mc = χ α + ˆσ open + α α (2) 2

4 All variables are measured as percen or percenage poin deviaions from heir seady sae level, and for simpliciy, all foreign variables are se equal o heir seady sae values. 2 As in Clarida e al, he firs hree equaions represen he New Keynesian open economy IS curve, Phillips Curve, and moneary rule, respecively, ha joinly deermine he oupu gap (x = y y po ), price inflaion (π ), and he nominal policy rae (i ), wih he key difference ha equaion (3) requires he policy rae o remain above is lower bound ( i). Thus, he oupu gap x depends inversely on he deviaion of he real ineres rae (i π + ) from is poenial rae r po, wih he sensiiviy parameer ˆσ open varying posiively wih he household s ineremporal elasiciy of subsiuion in consumpion σ and rade price elasiciy ε P (he relaive weigh on he laer rises wih rade openness ω). Given he Calvo-Yun conrac srucure, equaion (2) indicaes ha he Phillips Curve slope κ p varies direcly wih he produc of parameers deermining he sensiiviy of inflaion o marginal cos κ mc and of marginal cos o he oupu gap φ mc (he laer depends inversely on he Frisch elasiciy of labor supply χ, he parameer ˆσopen, and he labor share in producion ( α)). From equaion (5), a conracion in governmen spending g (where g y is he governmen spending share of seady sae oupu) or negaive ase shock ν (where ν c is a scaling parameer) reduces poenial oupu y po. Even so, boh of hese exogenous shocks, if negaive, cause he he poenial erms of rade τ po o depreciae (a rise in τ po in equaion 6) because hey depress he marginal uiliy of consumpion (e.g., lower governmen spending booss privae consumpion). If boh shocks follow AR() processes, and hence have fron-loaded effecs, a reducion in governmen spending or negaive ase shock reduces he poenial real ineres rae r po. Finally, equaions (8) and (9) are ideniies for he price level (p ) and he nominal exchange rae (e ). Given ha he form of he equaions deermining oupu, inflaion, and ineres raes is idenical o ha in a closed economy as emphasized by Clarida e al resuls from exensive closed economy analysis are direcly applicable for assessing he impac of governmen spending shocks in a liquidiy rap. We nex consider how he model is modified for he CU case. A CU member akes he nominal exchange rae as fixed, so ha he erms of rade τ is simply he gap beween home and foreign price levels, i.e., τ = (p p ) = p. 3 Moreover, he home economy is assumed o be small 2 We use he noaion y +j o denoe he condiional expecaion of a variable y a period + j based on informaion available a, i.e., y +j = E y +j. The superscrip po denoes he level of a variable ha would prevail under compleely flexible prices, e.g., y po is poenial oupu. 3 In his model, he erms of rade is equivalen o he real exchange rae using domesic price deflaors; hence, we use he erms inerchangeably. 3

5 enough ha he policy rae is effecively exogenous. Given ha equaion (4) implies ha he oupu gap is proporional o he erms of rade gap, i.e., x = ˆσ open (τ τ po ), he price seing equaion (2) may be expressed as a second order difference equaion in he erms of rade: which has he soluion: τ τ = β(τ + τ ) + κ pˆσ open (τ τ po ), (3) τ = λτ + κ pˆσ open λ βρλ τ po, (4) The persisence parameer λ =.5(a a 2 4/β ), where a = ( β )(+β +κ pˆσ open ), lies beween and uniy, and ρ is he persisence of he shock processes (assumed o be he same for he ase shock and governmen spending). Equaion (4) has wo imporan implicaions. Firs, because λ >, a conracion in governmen spending which raises τ po direcion, implying a depreciaion. by equaion (6) moves τ in he same Togeher wih equaion (4), his implies ha he governmen spending muliplier m is sricly less han uniy, i.e., m = g y dy dg = + g y ha τ po dτ po dg dτ dτ po dτ po dg < (recalling < ). Second, as κ pˆσ open becomes very small, λ rises oward uniy and he coeffi cien on shrinks, implying very gradual adjusmen of he erms of rade o τ po (and hence o a change in governmen spending); conversely, he erms of rade adjusmen is much more rapid if κ pˆσ open is larger. In economic erms, he erms of rade adjuss more quickly if he Phillips Curve has a relaively high slope (high κ p ), or if aggregae demand is relaively sensiiviy o he erms of rade (high ˆσ open ). 2.. Simulaion Resuls The lef panel of Figure shows he effecs of a percen of baseline GDP cu in governmen spending under a calibraion in which he Phillips Curve slope relaing inflaion o marginal cos κ mc =.25. This calibraion is owards he higher side of empirical esimaes, while he righ panel shows a calibraion which ses κ mc =.7, owards he very low end of empirical esimaes. If facors were compleely mobile, hese calibraions would imply mean price conrac duraions of abou 7 and 2 quarers, respecively, bu as emphasized by an exensive lieraure (e.g., Alig e al., 2) he reduced form slopes could be regarded as consisen wih much shorer conrac duraions under reasonable assumpions abou sraegic complemenariies. panels, he poenial erms of rade τ po As seen in he upper depreciaes (rises) iniially, and hen dies ou slowly a 4

6 he rae ρ =.95. This fall in he relaive price of domesically-produced goods reflecs ha he governmen spending cu booss home consumpion relaive o foreign consumpion. he posiive wealh effec reduces poenial oupu y po Moreover, (lower panels). A counry wih an IMP if unconsrained by he zero lower bound could achieve his flexible price allocaion simply hrough a moneary rule (3) ha responded very aggressively o inflaion. of rade τ would rack τ po Under such a rule, he erms exacly, and given ha inflaion remained unchanged from baseline, boh he real and nominal ineres rae would decline in line wih r po would be expeced o fall afer is iniial rise). degree of price sickiness. Thus, oupu would rack y po (reflecing ha consumpion irrespecive of he Wih he price level consan, he jump in he real exchange rae would be achieved hrough nominal exchange rae depreciaion. Because he nominal exchange rae is fixed in a CU, he governmen spending cu iniially booss τ po rade gap τ τ po much more han he acual erms of rade τ (upper panels). The negaive erms of o fall persisenly below poenial. which may be regarded as an overvalued erms of rade causes oupu The negaive oupu gap causes inflaion o fall persisenly implying a progressive depreciaion of he erms of rade and he progressive narrowing of he erms of rade gap evenually moves oupu owards poenial. As noed previously, he adjusmen process proceeds more quickly wih shorer-lived price conracs, which explains why he oupu conracion in he lef panel is smaller and less persisen han in he righ panel. In addiion, facors ha raise he sensiiviy ˆσ open of demand o he erms of rade such as a higher elasiciy of demand for raded goods would also speed-up he adjusmen. Imporanly, alhough he erms of rade adjus sluggishly in line wih he price level, i does a leas move in he righ direcion for narrowing he oupu gap. Moreover, as highlighed by Corsei e al. (2), he ex ane long-erm real ineres rae acually falls in response o a emporary fall in governmen spending: alhough inflaion declines in he near-erm, he erms of rade (and hence price level) mus evenually rever o seady sae, implying some rise in long-run expeced inflaion. 4 While greaer price flexibiliy cushions he impac of a governmen spending cu in a CU, more price flexibiliy or more generally, a more upward sloping Phillips Curve slope can grealy deepen he conracion ha occurs under an IMP subjec o he zero bound consrain, and imply an oupu muliplier much larger han in a CU. In his vein, Figure shows he effecs of he governmen spending conracion under an IMP agains he backdrop of iniial condiions which imply an en quarer liquidiy rap (i.e., a negaive ase shock ha is scaled o induce a liquidiy 4 Wih a permanen fall in spending, he rise in long-erm real ineres raes would be very small. 5

7 rap lasing en quarers in he absence of he fiscal shock). reduces r po As he governmen spending shock while he policy rae remains fixed, he oupu gap would conrac even if expeced inflaion remained consan. However, he oupu conracion is reinforced by a persisen decline in inflaion ha is paricularly large when price adjusmen is relaively rapid (he lef panel). Thus, he peak oupu decline is.5 under he IMP, compared wih.8 in a CU. Imporanly, he large oupu decline under he IMP reflecs wo facors. Firs, long-erm ex ane real ineres raes rise subsanially, in conras o he decline ha occurs in a CU. Second, he rise in he real ineres rae under an IMP implies a perverse iniial appreciaion of he erms of rade (as seen in he upper lef panel). Thus, alhough he CU precludes he nominal exchange rae from adjusing, he lack of adjusmen serves o beer cushion oupu han he appreciaion ha occurs under an IMP. Under more sluggish price adjusmen, he muliplier is only abou.6 under an IMP, smaller han he muliplier of.9 in a CU. Wih inflaion much less responsive, long-erm real ineres raes fall under an IMP, and his allows a fron-loaded depreciaion of he erms of rade o cushion he impac on oupu. Overall, our resuls underscore ha he same condiions which end o miigae he effecs of fiscal consolidaion in a CU namely, an upward-sloping Phillips Curve end o exacerbae he effecs under an IMP consrained by he zero lower bound; and conversely, a flaer Phillips Curve ends o make an IMP look relaively more aracive, since he real exchange rae can immediaely adjus o lessen he bie on aggregae demand. While he resuls in Figure consider he specific case of a en quarer liquidiy rap, i is naural o ask how long a liquidiy rap is required for fiscal consolidaion o produce a more conracionary effec under an IMP han a CU. To address his quesion, Figure 2 plos he oupu response o percen of GDP conracion under differen assumpions abou he duraion of he liquidiy rap faced under an IMP (wih he longer-lived raps generaed by progressively largely adverse ase shocks). As in Figure, he lef panel adops he calibraion in which price adjusmen is relaively faser, while he righ panel assumes ha price adjusmen is slower. In he former case, he oupu conracion becomes much more pronounced as he liquidiy rap lenghens increasing in a convex fashion wih he muliplier in he case of a eigh quarer liquidiy rap exceeding he muliplier under a CU of.8 (he dashed line). Wih a hree year liquidiy rap, he spending muliplier is nearly 3, as a sharp rise in long-erm real ineres raes (caused by lower expeced inflaion) causes a large improvemen in he erms of rade (lower panel) In his environmen, he anchoring of he long-run price level provided by a CU is clearly very beneficial in insulaing he economy from he 6

8 poenial pressures ha can arise in a liquidiy rap. By conras, wih long-lived 2 quarer price conracs, he liquidiy rap mus las 2 quarers for he muliplier under an IMP o exceed ha under a CU; for liquidiy raps of less han wo years, he fron-loaded depreciaion of he erms of rade (lower righ panel) significanly miigaes he effecs of he spending cu on oupu. he slope of he Phillips Curve becomes flaer, he liquidiy rap duraion required o produces a larger oupu downurn han in a CU becomes progressively longer. Our analysis has focused on a simple model ha absracs from an array of empirically-relevan nominal and real fricions. Even so, our key poins coninue o hold in more realisic open economy seings. Figure 3 shows responses o a percen of GDP fiscal conracion in a larger-scale open economy model used in Erceg and Lindé (2) ha embeds nominal wage and price rigidiies, endogenous capial accumulaion, rule-of-humb consumers, and incomplee exchange rae passhrough in he shor-run. The lef panel wih faser price adjusmen adops a calibraion of he price and wage conrac duraion parameers ha is broadly represenaive of he esimaes of he slopes of price and wage Phillips Curves based on daa prior o he financial crisis, and specifically, adops he esimae of Alig e al. (2) of κ mc =.4. The righ panel shows esimaes under an alernaive calibraion ha imposes an exremely fla price (and wage) Phillips Curve of κ mc =.2. 5 The unconsrained IMP follows a Taylor rule, while he consrained policy is derived under he assumpion ha he liquidiy rap lass en quarers. Under he calibraion wih relaively faser price adjusmen, oupu declines over 2 percen afer 4 quarers under he consrained IMP, compared wih only abou.7 percen in a CU. The larger oupu decline in he former case reflecs a larger fall in inflaion (middle lef panel) which pushes up long-erm real ineres raes and a sizeable real appreciaion of he exchange rae. Thus, he fiscal shock is amplified by a sharp conracion in privae domesic demand and real ne expors. In a CU, he real exchange rae depreciaes slighly even in he near-erm, and he long-erm real ineres rae is abou consan. By conras, under very slow price adjusmen he righ panel he effecs of fiscal consolidaion on oupu are modesly smaller under a consrained IMP han CU. The smaller oupu decline under an IMP reflecs boh a fron-loaded exchange rae depreciaion and fall in long-erm real ineres raes (since inflaion barely moves, and policy raes fall afer wo years). For a shor-lived liquidiy rap, he advanages of an IMP are even larger. 5 Under faser price adjusmen, he conrac duraion parameers for prices and wages are ξ p =.86 and ξ w =.82, respecively, while ξ p =.95 and ξ w =.9 under slower price adjusmen. The model and calibraion of oher parameers are described in Erceg and Lindé (2). As 7

9 3. Implicaions and Open Quesions Condiional on some key srucural parameers, including hose highlighed above, our modeling framework has clear implicaions o help gauge wheher he oupu effecs of fiscal consolidaion in an economy such as he Unied Kingdom where policy raes are consrained by heir ZLB are likely o be larger han in a CU member such as Porugal or Belgium. Bu given ha even he qualiaive answer hinges on facors ha deermine he responsiveness of inflaion, which view does he evidence favor? There is a subsanial amoun of economeric evidence esimaing he sensiiviy of price inflaion o marginal cos, and of wage inflaion o he wage markup; as noed, he calibraion in he lef panel of Figure 3 seems squarely in line wih such evidence. On his basis, fiscal consolidaion would have a significanly deeper conracionary impac on an open economy provided ha moneary policy were consrained for a period exceeding wo years; and he seeming sricures of a CU would in fac ameliorae he oupu conracion. Moreover, he relaive impac under an IMP would appear even more dire in he case of a longer-lived rap, or if price and wage-sensiiviy were somewha higher. However, he resilience of inflaion during he recen global recession suggess he possibiliy ha he responsiveness of inflaion may be considerably lower han implied by mos exising economeric evidence. As seen in he lef panel of Figure 3, he percen of GDP fiscal conracion reduces inflaion sharply by around 2 percenage poins. Moreover, under he same calibraion of price adjusmen, a fall in oupu of say 6-8 percen or more below is pre-crisis rend pah as was experienced by he Unied Saes and Europe during he recen recession would imply a fall in boh inflaion and one-year ahead expeced inflaion of more han 4 percenage poins below he cenral bank s perceived inflaion arge if mainly driven by aggregae demand shocks. This implied decline is much larger han acually occurred in eiher he Unied Saes, where core inflaion and marke expecaions of core inflaion have remained well above percen, or in major economies in Europe. I is quie conceivable ha inflaion behavior during he pas few years can be raionalized as consisen wih economeric evidence based on pre-crisis observaions. For example, financial shocks and oher shocks may have adversely impaced he supply side of he economy enough o accomodae observed inflaion behavior wihin he range of exising economeric evidence. However, fuure analysis may well poin o a somewha lower degree of inflaion responsiveness. If so, 8

10 ouside of a very prolonged liquidiy rap, our analysis would indicae ha an economy wih an IMP may be somewha beer poised o absorb he effecs of fiscal consolidaion han a CU, wih real exchange rae and ineres movemens ending o cushion raher han amplify he impac. 9

11 References Alesina, Albero and Robero Peroi (997), Fiscal Adjusmens In OECD Counries: Composiion and Macroeconomic Effecs, Inernaional Moneary Fund Saff Papers 44, Alig, David, Chrisiano, Lawrence J., Eichenbaum, Marin and Jesper Lindé (2), Firm-Specific Capial, Nominal Rigidiies and he Business Cycle, Review of Economic Dynamics 4(2), Clarida, Richard, Jordi Galí and Mark Gerler (2), Opimal Moneary Policy in Open Versus Closed Economics: An Inegraed Approach, American Economic Review Papers and Proceedings 9, Chrisiano, Lawrence, Marin Eichenbaum and Sergio Rebelo (2), When is he Governmen Spending Muliplier Large? Journal of Poliical Economy 9(), Corsei Giancarlo, Keih Kueser, and Gerno J. Muller (2), Floas, Pegs, and he Transmission of Fiscal Policy, forhcoming in Cespedes, L., and Gali, J. (eds.): Series on Cenral Banking, Analysis, and Economic Policies, Vol. XVII, Cenral Bank of Chile. Coenen G. and co-auhors (2), Effecs of Fiscal Simulus in Srucural Models, American Economic Journal: Macroeconomics, forhcoming. Davig, Troy and Eric M. Leeper (29), Moneary-Fiscal Policy Ineracions and Fiscal Simulus, European Economic Review 55(2), Eggersson, Gaui (2), Wha Fiscal Policy Is Effecive a Zero Ineres Raes?, NBER Macroeconomics Annual 25, Erceg, Chrisopher and Jesper Lindé (2), Is There A Fiscal Free Lunch In a Liquidiy Trap?, Inernaional Finance Discussion Papers No. 3. Erceg, Chrisopher and Jesper Lindé (2), Asymmeric Shocks in a Currency Union wih Moneary and Fiscal Handcuffs, NBER Inernaional Seminar on Macroeconomics 2, Galí, Jordi and Tomasso Monacelli (28), Moneary Policy and Exchange Rae Volailiy in a Small Open Economy, Review of Economic Sudies 72(3), Woodford, Michael, 2, Simple Analyics of he Governmen Spending Muliplier", American Economic Journal: Macroeconomics 3(), -35.

12 Figure : Persisen Conracion in Governmen Spending Fas Price Adjusmen Slow Price Adjusmen Terms of Trade Terms of Trade.5.5 Percen Percen Quarers.5 Ind. Policy, q Liq. Trap Currency Union Poenial Quarers Inflaion (APR) Inflaion (APR).5.5 Percen.5 Percen Quarers Quarers Oupu Oupu.5.5 Percen Percen Quarers Quarers

13 Figure 2: Impac Oupu Response o Immediae Governmen Spending Cu Wih Independen Moneary Policy and in a Currency Union Fas Price Adjusmen Slow Price Adjusmen Oupu Oupu.5.5 Percen Liquidiy Trap Duraion 2 Percen Independen Policy Currency Union Poenial Liquidiy Trap Duraion 2 Terms of Trade Terms of Trade.5.5 Percen.5 Percen Liquidiy Trap Duraion Liquidiy Trap Duraion 2

14 .5 Figure 3: Persisen Governmen Spending Cu in Large Model Faser Price Adjusmen Slower Price Adjusmen Real Exchange Rae Real Exchange Rae.5 Percen.5 Percen Quarers Inflaion (APR) Quarers Inflaion (APR) Percen.5.5 Percen.5.5 Ind. Policy, q Liq. Trap Currency Union Ind. Policy, Unconsrained Quarers Oupu Quarers Oupu.5.5 Percen.5 Percen Quarers Quarers