Fiscal policy, pricing frictions and monetary accommodation

Transcription

1 Fiscal policy, pricing fricions and moneary accommodaion 1 Fiscal policy, pricing fricions and moneary accommodaion Fabio Canova and Evi Pappa ICREA- Universia Pompeu Fabra, ICREA-UPF, BGSE, CREI, CREMeD, and CEPR; Universia Auonoma de Barcelona, BGSE and CEPR Absrac This paper empirically invesigaes wheher he heoreical condiions for governmen expendiure expansions o be effecive hold for he daa. We ask wheher he necessary condiions for fiscal effeciveness are relevan on average, and in special circumsances ha capure feaures of he recen crisis. Fiscal policy can be an effecive counercyclical ool if moneary policy accommodaes he fiscal expansion; if expecaions abou fuure oupu growh and inflaion are consan; and if srucural relaionships are invarian o he policy change. Recen expansions are unlikely o produce large oupu mulipliers or have imporan deb or inflaion effecs. Credible defici and deb reducion schemes can produce sizable oupu mulipliers. Prepared for he Economic Policy Panel, Budapes We would like o hank Paolo Surico, Mike Deveraux, Sefano Gnocchi, Heaher Anderson, Adrian Pagan, Bruce Preson, hree anonymous referees, and paricipans in ACQM 2010, he KDI conference Recen Developmens of dynamic analysis in Economics and seminars a CREI and REES for commens and suggesions. The Managing Edior in charge of his paper is Tullio Jappelli

2 Fiscal policy, pricing fricions and moneary accommodaion 2 1. Inroducion The indusrialized world has suffered a number of large negaive shocks in he las few years, iniially driven by sharp declines in house and sock prices and by a ighening of credi and financial condiions. Policy insiuions responded o he collapse in oupu wih measures ha deal wih he solvency of financial insiuions. Cenral banks, on he oher hand, reduced ineres raes o unprecedenedly low levels and used nonconvenional quaniaive or credi easing measures o reduce risk premia and o provide liquidiy o he financial secor. Despie hese effors, credi remains igh and aggregae demand has weakened rapidly. There have been imporan spillovers o less developed counries, increasing concern ha he world economy migh be moving ino a deep and prolonged recession. Given a siuaion where nominal ineres raes approached or hi he zero bound and he banking sysem was misfuncioning, he scope for furher moneary simulus was limied and aenion urned o fiscal policy. A he beginning of 2009, in a bid o susain employmen and growh, governmens around he world announced wo-year simulus packages ha were exraordinary in heir breadh and size (up o 2% of naional GDP). The US Congress, for example, approved $787 billion of addiional spending, ransfers and ax reducions wih he 2009 American Recovery and Reinvesmen Ac and he European Union iniiaed he European Economic Recovery Plan, while naional governmens announced heir own plans, see, for example, he Paccheo Fiscale in Ialy, Plan E in Spain, he Plan de Relance in France, he Konjunkurpake I & II in Germany and he Pre-Budge Repor in he UK. The legislaion raised old quesions abou effeciveness of emporary expendiure expansions for lessening he deph and duraion of a recession, bu also new ones regarding he preferred mix of fiscal acions. In Europe, expansionary impulses were considerably reduced during 2010 by he sovereign deb crisis, which followed he adjusmens needed o bring fiscal solvency o Greece and Ireland and quesioned he susainabiliy of he deb ha would accumulae wih he planned packages. The US legislaed for addiional expendiure for infrasrucures, and credi for he auomobile and he housing indusries, bu concerns emerged abou he magniude of he deb. In addiion o concerns abou he long-run susainabiliy of deerioraing fiscal posiions, quesions concerning he inflaion consequences and he long run crowding-ou effecs of deb accumulaion were being asked wih increasing frequency. I has been difficul o assess he economic impac of hese programs and he recen reversal of spending plans combined wih aemps a deb consolidaion, have made he ask even more complicaed. Several auhors have ried o measure he effecs of hese measures, bu findings are conradicory (see e.g. Romer and Bernsein, 2009; Cogan e

3 Fiscal policy, pricing fricions and moneary accommodaion 3 al., 2010; Cwik and Wieland, 2009). Proponens of fiscal simulus ypically emphasize Keynesian muliplier effecs: when consumpion is a funcion solely of afer-ax income, a defici-financed increase in governmen spending booss oal spending more han one for one. The increase in oupu produces increased revenues able o conain or even eliminae he increased governmen deb if he fiscal simulus is properly phased-ou. Since in globally inegraed economies, domesic spending may be divered parly o impors, proponens of fiscal expansions have called for coordinaed acion, boh across he Alanic and wihin Europe. Criics of fiscal simulus argue ha governmen spending displaces privae spending and reduces domesic compeiiveness. Defici financed spending increases may drive real ineres raes up, inducing increased privae savings and reduced privae expendiure. In addiion, if he erms of rade are posiively correlaed wih real ineres raes, he foreign spending componen also may be reduced. Finally, since he real ineres rae increases, deb may rise quickly o an unsusainable level, requiring correcive measures. The combinaion of iniial expendiure increases and expendiure cus or ax increases a laer daes, may generae perverse oupu effecs. This bleak oulook is no shared by all criics of fiscal simulus. By reducing deb, governmens may generae expecaions of permanenly lower fuure coss (lower principal and lower ineres paymens) and simulae curren privae spending via a permanen income mechanism. Thus, deb consolidaion could be expansionary raher han conracionary. Unforunaely, he empirical evidence on his issue is similarly inconsisen (see e.g. Coenen e al., 2008; Forni e al., 2010; Afonso, 2010). In general, he uncerainy surrounding he consequences of fiscal measures reflecs he lack of consensus on he likeness beween developed economies and a pure Keynesian framework. Proponens of fiscal simulus argue also ha he curren condiions are special, in he sense ha neiher he evidence from hisorical daa nor he predicions of heoreical models are well suied o explaining he effecs of governmen spending increases and deb consolidaion schemes in oday s climae. The fac ha many cenral banks are more likely o keep ineres raes low for a proraced ime period makes he exising empirical evidence less relevan, because informaion on he effecs of fiscal simulus emerges when cenral banks ac more aggressively o keep down inflaion and inflaion expecaions. Similarly, calibraion exercises based on dynamic sochasic general equilibrium models may no provide reliable informaion abou he effecs of planned governmen spending increases, even if he models are correcly specified and policy acions appropriaely designed, because he hisorical parameers are unlikely accuraely o describe curren condiions. For example, he responsiveness of he labor supply o fiscal expansion may be sronger when unemploymen raes are high, as suggesed by Barro and Redlick (2009), and expecaions of deb susainabiliy may be sae dependen. Hall (2009) and Woodford (2011) use simple analyical frameworks wihin he

4 Fiscal policy, pricing fricions and moneary accommodaion 4 mainsream New Keynesian paradigm, o undersand he effecs of governmen spending in general, and o evaluae in wha sense curren condiions are special relaive o hisorical experience. Coenen e al. (2010) perform similar exercises in seven large scale models used by he policy insiuions in he developed world. The conclusions reached by hese auhors are simple: in normal condiions, expendiure increases induce modes aggregae demand effecs. The shor run effecs could be magnified if spending increases come wih provisions for fuure spending cus (bu no fuure ax increases); if moneary policy is accommodaive; if pricing fricions are imporan; or if price markups are srongly counercyclical. Finally, Chrisiano e al. (2009) and Erceg and Lindé(2010) show ha i is he lengh of ime over which he zero bound applies and he iming of expendiure increases, ha deermine he deb coss and he oupu effecs of he measures. This paper invesigaes empirically wheher he heoreical condiions for governmen expendiure expansions o be effecive, hold for he daa. We ake he predicions from a large class of New Keynesian models currenly in use in academic and policy insiuions, a face value, and ask wheher he necessary condiions for fiscal effeciveness are relevan, on average and in special circumsances ha capure he feaures of he curren siuaion. We wan o evaluae he jusificaion for he claim ha curren expansions will produce consequences differen from hose obained in hisorical episodes and o ask wheher (i) oupu mulipliers should be larger, (ii) deb migh become unconrollable, and (iii) inflaion responses migh give moneary auhoriies room o maneuver nominal ineres raes. Our focus is on shor-run effeciveness bu occasionally we discuss he long-run consequences of he curren measures. We sudy hese quesions using a srucural VAR model. We apply sae-of-he-ar echniques o produce shocks wih he required characerisics, and explicily quanify he uncerainies due o parameer esimaes and shock idenificaion. We recover spending shocks using sign resricions on he response of expendiure, deficis and oupu growh, and disinguish beween normal siuaions and he curren one by imposing addiional consrains on he dynamics of ax receips, inflaion and he magniude of he shocks. We evaluae he effecs of consolidaion schemes by imposing furher resricions on he dynamics of deficis or deb. To verify he predicions of he heory, we focus aenion on he responses of he real ineres rae, which is deermined by he ineracion of fiscal and moneary policy decisions; of he real wage and of he labor wedge, which depend, among oher hings, on he fricions presen in he labor and goods markes. A unique feaure of our invesigaion is ha we compare he effecs of expansionary spending shocks in he US, he Euro area (EA) and he UK. While one migh surmise ha he same measures may no be appropriae o expand oupu (and decrease unemploymen) for all counries and all saes of he world (as noed in Spilimbergo e

5 Fiscal policy, pricing fricions and moneary accommodaion 5 al., 2009), mos empirical analyses fail o draw general conclusions abou he suiabiliy of curren packages because hey focus on he experience of individual counries. Given he heerogeneiies in size, produc marke regulaion and labor marke rigidiies in he hree economies we sudy, our analysis should shed ligh on wheher and when fiscal policy could be used o boos aggregae demand, and also provide informaion abou he role of marke fricions and insiuions in deermining he magniude of oupu mulipliers. Our work differs from he exising sudies along a number of oher dimensions. Firs, raher han focusing on consumpion and invesmen responses, we sudy he dynamics of he real wage, real ineres rae and he labor wedge since, in heory, his provides he mos reliable informaion on he quesions of ineres. Second, while he policy debae focuses on he magniude of he oupu effecs ha can be expeced from curren packages, we are ineresed in assessing wheher he economic condiions for which hey were designed could make fiscal expansion play a larger role han hisorically. Third, our focus on he ineracion beween fiscal and moneary policies allows us o sudy wheher a lack of coordinaion has reduced he poenial effeciveness of fiscal policy. Finally, since nominal rigidiies, in heory, are crucial o deliver sizeable mulipliers, our invesigaion provides an indirec es of he appropriaeness of he mainsream New- Keynesian paradigm. Our analysis concenraes only on he effecs of governmen consumpion expendiure shocks - increases in governmen consumpion accoun for over 60 percen of he oal amoun of he legislaed packages. This resriced focus does no allow us o analyze which fiscal insrumen migh be more effecive o lessen he curren recession, for example, bu has he advanage of mainaining a igh link wih he curren siuaion. There are a few oher caveas. Firs, our analysis almos compleely ses aside open economy consideraions, which prevens us from sudying win defici dynamics (see Corsei and Muller, 2006) and relaed issues. Second, he analysis disregards he problem of predicabiliy of fiscal shocks (see Leeper e al., 2009; Ramey, 2009; Merens and Ravn, 2008). This predicabiliy, which ypically is driven by legislaion and implemenaion lags, is imporan and may invalidae sandard empirical analyses. Since he general conclusions we obain are mainained even when expendiure shocks are predicable, we defer discussion of predicabiliy issues o a relaed work (Canova and Pappa, 2011). Finally, our empirical framework allows us o consider only cerain ypes of consumpion expendiure disurbances. Oher ineresing shocks, for example, fiscal disurbances ha occur in combinaion wih financial disurbances and which may generae imporan non-linear effecs, need o be analyzed wih more complicaed nonlinear and ime varying coefficien models. The res of he paper is organized as follows. Secion 2 highlighs he heoreical consideraions ha guide our empirical analysis and reviews he lieraure. Secion 3 describes he daa and he mehodology. Secion 4 presens our findings. Secion 5

6 Fiscal policy, pricing fricions and moneary accommodaion 6 summarizes he resuls and highlighs some policy conclusions. 2. Some heoreical consideraions There is a considerable debae in he lieraure concerning he domesic effecs of unexpeced expendiure increases or ax reducions and heir inernaional spillovers. Much of he argumen focused iniially on eiher he sign of he impac responses of consumpion and invesmen or he magniude of oupu mulipliers. Since his lieraure is no concerned wih normaive saemens, he presumpion is ha he larger he responses of eiher oupu or some of is privae expendiure componens, he more benign is he policy. Empirically, he sign of consumpion and invesmen responses is conroversial: posiive and negaive responses are found depending on he model specificaion and he exac measuremen of he variables (see, e.g., Blanchard and Peroi, 2002; Burnside e al., 2004; Caldara and Kamps, 2008). There is also considerable heerogeneiy in he magniude of he esimaed oupu mulipliers wih values varying from 0.5 o 3 obained (see e.g., Mounford and Uhlig, 2009; Barro and Redlick, 2009; Romer and Bernsein, 2009) Consumpion and invesmen responses: he heory Exising closed economy general equilibrium heories make clear predicions regarding he sign of consumpion responses and he magniude of oupu mulipliers in response o governmen consumpion spending shocks, bu are less cerain abou he sign of he invesmen responses. Wih sandard ime addiive preferences and a compeiive labor marke, when governmen expendiure is unproducive and yields no uiliy o privae agens, emporary, defici financed, governmen expendiure increases crowd ou privae consumpion and generae oupu mulipliers ha are below 1. This is rue for boh neoclassical and New Keynesian models, and in he laer case when eiher price or wage fricions or boh are presen, as long as moneary policy is conduced wih a sandard Taylor rule (a model wih hese predicions is in appendix A). The reason for his oucome is simple. Increases in governmen consumpion expendiure reduce he porion of oupu available for privae uses. Thus, unless agens increase producive inpus considerably, eiher consumpion or invesmen or boh mus fall. The negaive wealh effec increases labor supply, bu he effec on capial inpu is ambiguous. In general, when he producion funcion displays decreasing reurns o scale, oupu will increase by less han he increase in governmen consumpion. Since a permanen income moive is in place in hese models, he increase in public defici will increase he real rae, making privae savings increase o mach he fall in public savings. The oupu effecs of expendiure increases may be magnified if public consumpion expendiure yields uiliy (see e.g. Bouakez and Rebei, 2007) or creaes producion exernaliies (see e.g., Baxer and King, 1993). The effecs may also be larger if

7 Fiscal policy, pricing fricions and moneary accommodaion 7 preferences are represened wih differen funcional forms (see e.g., Monacelli and Peroi, 2008), if increasing reurns o scale are allowed in producion (see Deveraux e al., 1996), or if a share of agens consumes a consan fracion of income (see e.g. Galí e al., 2007). However, even in hese cases, i is difficul simulaneously o produce oupu mulipliers higher han 1 and consumpion responses ha are significanly posiive. In ligh of he measuremen errors in consumpion and oupu daa and he conradicory empirical evidence on he dynamics of hese variables, several auhors have ried o assess he effecs of governmen consumpion expendiure disurbances using easier omeasure or empirically less conroversial variables. For example, Roemberg and Woodford (1992) and Galí e al. (2007) look a he dynamics of hours, while Caldara and Kamps (2008) and Burnside e al. (2004) examine a number of macroeconomic variables and secoral aggregaes. These sudies add valuable empirical informaion, bu robus sylized facs are scarce, leading o inconsisen conclusions Real wage dynamics Hall (2009) and Woodford (2011) examine he condiions under which governmen consumpion expendiure shocks can have large oupu effecs and induce posiive consumpion dynamics, in models feauring a variey of marke arrangemens and governmen policies. Their analyses indicae ha a necessary condiion for boh oucomes o be rue is ha he equilibrium real wage subsanially increases in response o he shock. Wihou i, he increase in employmen will be mued, rendering oupu expansion limied. As emphasized in Pappa (2009), he dynamics of he real wage in response o governmen spending shocks can be used o es neoclassical versus New Keynesian models of ransmission. In neoclassical models an increase in governmen spending raises labor supply because of a negaive wealh effec. Wih perfec compeiion and diminishing reurns o labor, he shif in labor supply increases hours and drives produciviy and real produc wages down (see firs box in figure 1). In New Keynesian models wih imperfec compeiion, booms produce price wars lowering he price markup over marginal cos charged by monopolisic compeiive firms, and raising boh real wages and hours despie a produciviy decline. The second box in figure 1 indicaes ha labor supply and labor demand boh move, making i possible for real wages o increase; if he slope of he curves and he magniude of he movemens are convenional, employmen migh expand more han in he firs box. Allowing for increasing reurns o scale in producion, a governmen spending increase raises real produc wage, hours and produciviy (see e.g. Deveraux e al., 1996). The hird box in figure 1 shows ha he labor demand curve is upward sloping in hese models. Thus, shifs in he labor supply curve lead o subsanial increases in real wages and employmen wihou he need for he labor demand curve o move.

8 Fiscal policy, pricing fricions and moneary accommodaion 8 Empirically, lile is known abou he dynamics of real wages in response o governmen spending shocks. Pappa (2009) and Peroi (2007) repor increases in aggregae real wages in US saes, and in a number of OECD counries; Nekarda and Ramey (2011) find ha real wages fall a he indusry level when here is an increase in governmen demand for he goods produced by ha indusry. These differen conclusions appear o be relaed o he measuremen of real wages, ha is, wheher nominal wages are deflaed by CPI (consumpion real wage) or by he GDP deflaor (producion real wage). Regardless of hese measuremen issues, he magniude of absolue changes in real wages is generally moderae, casing doub on he possibiliy of generaing large muliplier effecs hrough he labor supply channel Efficiency wedge dynamics Hall (2009) and Woodford (2011) indicae ha expansionary governmen consumpion expendiure shocks will have large posiive effecs on oupu and consumpion if he labor-efficiency wedge, ha is, he inverse of he difference beween real wages and he marginal produc of labor, responds negaively o governmen spending shocks. This condiion is closely relaed, bu no equivalen o he previous real wage condiion since he efficiency wedge may display he correc cyclical behavior even if he real wage does no. In sandard neoclassical models, even under he assumpion of monopolisic compeiion, he efficiency wedge is consan. To make i ime varying, nominal sickiness is ypically added. As already menioned, increases in governmen expendiure increase hours, reduce he marginal produc of labor, and increase marginal coss. If prices canno be adjused insananeously, he labor-efficiency wedge mus fall o ensure ha labor marke equilibrium is achieved. If he sensiiviy of he labor wedge o oupu changes is large, sizeable mulipliers can be creaed because he aggregae demand increase is ranslaed less ino price increases and more ino oupu expansions. Price sickiness is sufficien, bu by no means necessary o induce counercyclical movemens in he labor-efficiency wedge. For example, as discussed in Roemberg and Woodford (1992), if an increase in governmen expendiure reduces he abiliy of producers o mainain collusion, mulipliers can be uniformly larger han in he case where producers have no marke power, even wihou price sickiness. Thus, i would be incorrec o use movemens in he labor-efficiency wedge in response o demand shocks o es he sicky price assumpion. Similarly, evidence of pro-cyclicaliy in he laborefficiency wedge does no signal failure of he sicky price heory, since counercyclical movemens are necessary only o increase oupu mulipliers. How does he efficiency wedge behave in response o governmen spending shocks? Nekarda and Ramey (2011) find ha increases in governmen demand which raise oupu and hours in a secor of he indusry, reduce produciviy and real produc wages, leaving he efficiency wedge roughly unchanged. Some ineresing evidence repored by Gali e

9 Fiscal policy, pricing fricions and moneary accommodaion 9 al. (2007) and Ramey (2009) indicaes ha, in he aggregae, labor produciviy moderaely increases, making increases in real wages a necessary condiion and large increases in real wages a sufficien condiion for oupu mulipliers o be large The role of moneary policy Hall (2009) and Woodford (2011) indicae ha an unexpeced governmen consumpion increase will induce a large oupu expansion if moneary policy is accommodaive. Unexpeced increases in governmen spending normally creae inflaion. If he moneary auhoriy reacs srongly o inflaion, as would be he case in inflaion argeing regimes or when aggressive Taylor rules are in place, he real rae will increase, increasing privae savings. If, insead, an unexpeced governmen expendiure expansion is accompanied by a (emporarily) weak response of he nominal rae o inflaion, he real rae may fall, simulaing boh consumpion and invesmen expendiure. In he unlikely case where he real rae is unchanged afer a spending shock his requires a one-o-one adjusmen of he nominal rae o changes in inflaion - he oupu muliplier is 1, and privae spending will be unaffeced by he shock. Clearly, such a mechanism exiss only in New Keynesian models. In neoclassical models wihou paricipaion consrains and absracing from siuaions where fiscal policy provides a nominal anchor (see e.g. Leeper, 1991), privae decisions, raher han moneary policy, deermine he real rae of ineres. Here he real rae always increases in response o governmen consumpion spending shocks since is equilibrium value is obained from an Euler equaion wih predeermined consumpion growh. In sicky price models he abiliy of moneary policy o affec real variables via changes in he real rae of ineres, makes moneary and fiscal ineracions imporan as far as he magniude of he oupu muliplier is concerned. Wheher moneary policy helps or leans agains fiscal policy is an ineresing empirical quesion which we invesigae. Noice ha emporary deviaions from a Taylor principle do no necessarily affec he deerminacy of he equilibrium if fiscal policy responsibly curbs he resuling deb increase. Also, as long as deviaions are emporary, inflaion expecaions need no be affeced. In models wih sicky prices, he abiliy of fiscal policy o affec he real economy is magnified when he nominal ineres rae is suck a he zero bound. Conversely, well designed fiscal measures may release moneary policy from he liquidiy rap. A he zero bound, moneary policy is unlikely o respond o inflaion he preferences of moneary auhoriies are likely o shif in his siuaion. Thus, if expansionary expendiure shocks generae some inflaion, he real rae will fall making fiscal policy more effecive. An ineresing empirical quesion is wheher fiscal acions can generae inflaion in general, and especially when he nominal ineres rae is a zero. Hall (2011) suggess ha hey canno. I could be conjecured ha he fiscal simulus mus be large o be able o produce such an effec and ha were he recession which has driven he

10 Fiscal policy, pricing fricions and moneary accommodaion 10 nominal ineres rae o zero o be proraced, inflaionary effecs would be limied. On he oher hand, if fiscal policy succeeds in generaing inflaion, i can give he moneary auhoriies room o maneuver he nominal ineres rae. This would seem o be he view underlying many recen measures aken by he US Federal Reserve: he large increase in is balance shee, in is holding of governmen deb, and in he liquidiy poured ino he sysem are all consisen wih an aemp o make he real rae fall, and curren and fuure inflaion increase. Chrisiano e al. (2009) and Erceg and Linde (2010) emphasize ha he magniude of he oupu mulipliers depends on how much ime he economy spends a he zero ineres rae bound and on he iming of fiscal acions. In paricular, oupu mulipliers are larger when expendiure expansion is designed and implemened a he ime when a shock pushes he nominal ineres rae o he zero bound. In he simulaionshey run, implemenaion delays of jus one quarer can cu he oupu muliplier by half and make he deb cos of he expansions much larger. All hese consideraions sugges ha, in he curren condiions, ha is, when he nominal ineres rae is close o zero, unemploymen is high, inflaion is low, and growh prospecs are dim, fiscal expansions could have larger effecs han oherwise, and large fiscal acions are probably required o bring he economy back ono a growh rack Ceeris paribus assumpions Implici in he discussion in he previous hree subsecions are a number of a ceeris paribus assumpions, which i is useful o spell ou in deail. The firs is ha inflaion expecaions are unaffeced by governmen expendiure shocks. Boh he aggregae supply (Phillips) curve and he aggregae demand curve, in fac, depend on inflaion expecaions. If hey change when expendiure expands (e.g., because he policy is considered unsusainable), he oupu muliplier may be small, even in he ideal condiions we have described, and he inflaion increase larger han oherwise, because ouward movemens in he aggregae demand could be neuralized by inward movemens in he aggregae supply. Thus, i is imporan ha he fiscal expansion should no creae percepions of higher fuure inflaion. Conversely, he oupu effecs will be maximized when inflaion expecaions are non-increasing in he fiscal impulse. The second implici assumpion is ha, in response o expendiure changes, he sensiiviy of privae spending o he real ineres rae and oupu changes is unaffeced. For example, all he exercises assume ha, following he fiscal disurbances, consumpion does no become less sensiive o he real rae and more sensiive o curren income, making agens more Keynesian and less neoclassical. If he IS (Euler) curve is ime varying, because consumers become credi consrained or more pruden in cerain saes of naure, he aggregae demand curve may shif and roae backward,

11 Fiscal policy, pricing fricions and moneary accommodaion 11 making i difficul o predic he magniude and he direcion of he oupu changes. Finally, fuure oupu growh expecaions are assumed o be consan. In a dynamic seing, he aggregae demand curve is a funcion of fuure expeced oupu. If curren fiscal expansions change fuure oupu prospecs, for example, because agens expec higher fuure disoring axes, curren demand expansions may be parially undone by he expeced fall in fuure oupu growh. Thus, even if he heoreical condiions for fiscal effeciveness are saisfied, oupu mulipliers could be small, zero, or even negaive. Simple models are grea ools o build inuiion abou he mechanics of he ransmission of fiscal shocks, bu hey may be unsuiable o shed ligh on exising evens. Pracical experience indicaes ha models wih a richer se of secoral or cross-counry inerdependencies may make conclusions fuzzier. Luckily, for expendiure expansions, his does no appear o be he case. Coenen e al. (2010) examine he predicions of seven medium scale dynamic sochasic general equilibrium models used in policy circles and find ha he same mechanisms and he same rade-offs highlighed by Hall and Woodford are presen. Thus, he insighs obained from small scale, closed economy models can be used o analyze poenially open and complex real world economies A summary and empirical implicaions For governmen spending disurbances o have subsanial oupu effecs he following hree condiions should hold: (a) real wages should increase subsanially; (b) he laborefficiency wedge should fall considerably; (c) he real ineres rae should fall considerably. I is unclear which condiion is he mos imporan. The firs wo requiremens are likely o boos he supply side effecs of he shock, making he aggregae supply flaer; he las deermines he magniude of he aggregae demand shif. In he las case, non-negaive movemens in privae expendiure are necessary for oupu o increase following governmen expendiure shocks. However, unless he real wage increases sufficienly o moivae agens o supply he labor needed o make oupu expansions possible, unless he demand increase is ranslaed in quaniy raher han price expansions, and unless moneary policy is accommodaive, he increase in governmen expendiure will simply crowd ou privae demand or increase inflaion. To he bes of our knowledge, he lieraure does no examine wheher hese hree condiions hold in he daa, wheher hey are necessary for making oupu mulipliers large, wheher hey are more likely o hold in he special condiions characerizing oday s world economy and, more generally, wheher he predicions of models wih pricing fricions find sufficien suppor in he daa. Auerbach and Gorodnichenko (2010) sudy he effecs of fiscal policy in recessions and expansions and find hem o be differen. Kirchner e al. (2010) examine wheher he naure of he ransmission of fiscal shocks has changed over ime and noe ha he size of he long run oupu mulipliers

12 Fiscal policy, pricing fricions and moneary accommodaion 12 has declined. However, neiher of hese sudies addresses he quesions of ineres in his paper, nor do hey provide evidence on he ineracion beween labor markes, pricing fricions and moneary policy in deermining he oucomes of governmen spending disurbances. Mos heoreical analyses assume ha increases in governmen consumpion expendiure are financed wih lump sum axes or, if deb is generaed, ha evenually i will be scaled back via lump sum axaion. Furhermore, i is ypically assumed ha such policy does no affec governmen credibiliy or expecaions of fiscal susainabiliy. Uhlig (2010) highlighs an old, bu ofen overlooked issue: he financing of governmen expendiure maers. Under he more realisic assumpion ha only disoring axes are available, he oupu mulipliers generaed by a public expendiure expansion can be negaive he expeced disorions due o he ax increase dominae he employmen and oupu gains induced by he shocks. Furhermore, he speed wih which he governmen seeks o reurn he deb o is original level affecs he magniude and he sign of he mulipliers. An alernaive policy, poenially inducing large posiive oupu effecs, is one ha cus disoring axes now and increases hem in he fuure. Such a policy produces Laffer curve ype dynamics, making defici and deb accumulaion much smaller. In general, who finances he defici (domesic or foreign residens), how deb consolidaions are performed and wha insrumen is used, are all crucial for undersanding he effecs of fiscal changes. Lasly, i should be remembered ha fiscal expansions are unlikely o exercise an insananeous effec on he economy. Apar from gesaion and legislaive delays, here is evidence ha fiscal and moneary policies affec he variabiliy of real variables a differen frequencies. For example, Rossi and Zubairy (2009) show ha governmen expendiure shocks explain a large porion of oupu variabiliy in he medium run, bu a small fracion of oupu variabiliy a business cycle frequencies he opposie is rue for moneary policy. Thus, he fiscal lever may ake much longer han he moneary lever o exercise is effecs; he lack of noiceable oupu growh effecs in many OECD counries, despie he large fiscal impulse in 2009, is consisen wih his fac. 3. The daa and he empirical framework We use quarerly series for he US, he EA and he UK. US daa come from he Federal Reserve Bank of Sain Louis FRED daabase, he Bureau of Economic Analysis (BEA) and he Bureau of Labor Saisics (BLS); EA daa are from he Area-wide Model Daabase (version 9), and daa for he UK are from he OECD, and IFS saisics of he IMF. For each counry, he variables included in he VAR are: log raio of governmen consumpion expendiure o oupu; log raio of oal ax receips o oupu; log of 1 plus he annualized quarer-on-quarer growh rae of real per-capia oupu; log of 1 plus he

13 Fiscal policy, pricing fricions and moneary accommodaion 13 annualized quarer-on-quarer growh rae of real wages; log of 1 plus he ex-pos annualized real ineres rae; log of he efficiency wedge; log of 1 plus he annualized inflaion rae; log of 1 plus he yield on long erm governmen bonds; and he log of personal consumpion expendiure o oupu raio. Variables are scaled o ensure ha he VAR is roughly free from low frequency movemens. Appendix B describes he consrucion of each variable from he available raw series. For he EA we also consider he fiscal daabases in Paredes e al. (2009) and Forni e al. (2009). The series for governmen consumpion expendiure and for oal ax receips in he 1970s differ in he hree daa bases, primarily because of differen inerpolaion procedures used o ransform annual ino quarerly daa. From he early 1990s, he series largely overlap and heir correlaion is above 0.9. Thus, for he more recen period, which daase is used is immaerial. Since here is no cenral EA fiscal auhoriy, one migh wonder wha EA fiscal shocks represen. While his is a legiimae quesion, i should be remembered ha discreionary fiscal policy in he EA region has commoved srongly over he las 20 years (see e.g. Giuliadori and Beesma, 2008). In addiion, since EA fiscal variables are weighed averages of he corresponding counry specific variables, he shocks we consruc can be inerpreed as disurbances occurring in he counries wih he highes weighs in he EA. Ramey and Shapiro (1998) argue ha o properly measure he effecs of governmen expendiure shocks, real wages need o be compued deflaing nominal wages by a produc marke raher han a consumpion deflaor. While he difference is irrelevan in a one-secor model, in a wo-secor model he wo series can have differen dynamics. We consruced boh consumpion and produc real wages using CPI and he GDP deflaor. The consumpion real wage is more volaile and less correlaed o oupu, bu governmen spending shocks induce quie similar dynamics for he wo series. Thus, we presen only produc real wages responses. To measure he labor-efficiency wedge we considered wo differen series. One is profi share, ha is, he difference beween 1 and he labor share in oupu. This proxy is very rough and may be conaminaed by serious measuremen error. The second, which is more relaed o he heory, uses he difference beween he real wage and labor produciviy. While hese wo measures have differen levels, hey display similar cyclical flucuaions. Thus, we presen only he resuls obained using he firs measure. For compuaional convenience, in he VAR we employ he ex-pos real rae and he inflaion rae raher han he nominal ineres rae and he inflaion rae. The resuls we presen are unchanged if he dynamics of he ex-ane real rae (consruced using VAR based inflaion expecaions) are considered insead. The yield on long erm governmen bonds is no of direc ineres in he invesigaion and is used primarily o assess

14 Fiscal policy, pricing fricions and moneary accommodaion 14 deviaions from he ceeris paribus assumpions. The sample periods used o esimae he VAR depend on he counry considered. For he US we sar in 1984Q1 and end in 2009Q4, for he EA we sar a 1993Q1 and end in 2008Q4 and for he UK we sar in 1993Q1 and end in 2009Q4. The sar daes are chosen o mainain as much ime homogeneiy as possible. For comparabiliy, we also examine he sample 1993Q1-2009Q4 for he US: he resuls we repor are unaffeced by his change. In addiion, since daa for he US are available since he early 1950s, bu only since he early 1970s for he EA and he UK, we examine wheher conclusions change when a longer sample is considered. The qualiaive feaures of he resuls are insensiive o he sample period, bu sandard errors in he longer samples are larger, reflecing he presence of considerable ime heerogeneiy. We use four lags for each variable and a consan in he VAR and employ a Bayesian prior o conserve degrees of freedom. The prior is quie sandard (see e.g., Canova, 2007, ch. 9) and is described in appendix C; i allows analyical compuaion of he poserior disribuion of he VAR coefficiens. Using Mone Carlo echniques, we draw 2000 coefficien vecors from hese disribuions, and for each draw we ry o idenify a defici financed expansionary governmen consumpion expendiure shock imposing, a a minimum, hree insananeous sign resricions: (i) governmen consumpion expendiure increases; (ii) defici increases; (iii) he growh rae of oupu increases. To idenify fiscal shocks, sign resricions are preferable o more radiional resricions because hey can be made consisen wih he heory ha is used o inerpre he resuls for example, he model in appendix A robusly generaes hese resricions when he srucural parameers are allowed o vary wihin a reasonable range and when nuisance feaures, such as he specificaion of price sickiness, have differen represenaions (see e.g., Pappa, 2009). Perhaps more imporan for our purpose, sign resricions allow us o design expendiure shocks wih complex and realisic paerns more sandard approaches based on a riangular decomposiion of he covariance marix or he Blanchard and Peroi (2002) approach, lack his flexibiliy. Only conemporaneous resricions are imposed because exising heories have fragile dynamic predicions for he response of governmen defici and oupu growh. To ensure ha sign resricions hold sufficienly ofen, for each draw of he coefficien vecor, we draw up o 5,000 orhonormal marices roaing he covariance marix of he reduced form shocks appendix C explains he mehod. Thus, we perform up o 10,000,000 Mone Carlo exracions for each counry and in each scenario and, conrary o similar exercises in he lieraure, he responses we presen reflec boh coefficien and idenificaion uncerainy. Finally, we should sress ha, since he log of governmen consumpion expendiure o oupu and he log of oupu per-capia are used in he VAR, he mulipliers we consruc are consisen wih he heoreical mulipliers when populaion is exogenously growing and oupu growh, on average, is posiive, bu no direcly comparable o hose in he

15 Fiscal policy, pricing fricions and moneary accommodaion 15 empirical lieraure, which ypically employ he log of governmen consumpion expendiure and he log of oupu. To give an idea of how o compare hem, suppose ha populaion is consan and ha he parial derivae and he log operaors are inerchangeable - which is no necessarily he case. Then, as a firs approximaion he mulipliers in he lieraure are he square roo of he numbers we presen here. 4. The evidence To faciliae presenaion of our resuls, we spli he discussion ino pars. Firs, we describe he average responses of he hree variables of ineres, and of he per-capia oupu mulipliers o governmen consumpion expendiure shocks; averages are compued allowing for coefficien and idenificaion uncerainy. Second, o evaluae he imporance of he hree heoreical condiions, we compare oupu mulipliers wih he imposiion of addiional consrains. Third, we examine he responses of he hree variables of ineres and of per-capia oupu mulipliers in scenarios ha mimic he curren economic siuaion, and discuss he deb and inflaion consequences of fiscal expansion. Finally, we sudy he dynamics induced by expendiure expansions, which are accompanied by fuure defici and deb consolidaion provisions Sample Average responses Figure 2 shows he average responses of he real wage, he real rae of ineres, he labor-efficiency wedge and he per-capia oupu muliplier for horizons of up o 20 quarers. We repor he poin-wise median response (red circled line) and he poin-wise one sandard error poserior inerval (blue dashed line) a each horizon; row 1 refers o he US, row 2 o he EA, and row 3 o he UK. The daa are no very informaive abou he dynamics of he real wage, real rae of ineres and labor-efficiency wedge in response o defici financed expansionary governmen consumpion disurbances. In erms of poin esimaes, he real wage falls in he US and he UK, and increases in he EA; he real rae increases in he US and falls in he EA and he UK; and he labor wedge falls in he US and increases in he EA and he UK. However, in all hree regions, responses are insignifican a all horizons. We can sugges hree poenial reasons for his oucome. Firs, he shocks we idenify combine srucural shocks of differen ypes. I is difficul o conceive of meaningful heoreical disurbances whose impac implicaions for governmen consumpion expendiure, and defici and oupu growh are idenical o he ones considered here. Second, measuremen errors dominae. While his is a possible explanaion for he labor wedge measure, i is difficul o believe ha i is relevan for he real rae of ineres. Moreover, since boh he consumpion real wage and he produc real wage display similar responses, measuremen error canno be he main reason for lack of informaion in he daa. The

16 Fiscal policy, pricing fricions and moneary accommodaion 16 hird possibiliy is ha, in he samples we consider, here are episodes where defici financed expansionary consumpion expendiure shocks induce posiive responses from each of he hree variables, as well as episodes where responses are negaive. In oher words, he idenificaion resricions we employ are no sufficien o provide a precise view of he dynamics of hese variables. Labor markes, moneary policy and markups can reac boh ways, depending on circumsances which he analysis has no conrolled for. The dynamics of he real wage in he US are a odds wih he characerizaion of he empirical evidence in Ramey (2009). She claims ha in he US, he real wage increases when expendiure shocks are idenified wih VARs, and falls when hey are idenified wih large unexpeced miliary expansions. In conras, figure 1 shows ha he median impac response of he real wage is negaive in our VAR. More imporanly, our figure indicaes ha, unless oher resricions are imposed, he response of he real wage canno be signed wih high probabiliy a any horizon. Perhaps unsurprisingly, given ha we are unable o sign he response of he hree variables ha he heory singles ou as crucial for undersanding he magniude of he oupu effecs of governmen expendiure shocks, we can also no say much abou he magniude of he per-capia oupu mulipliers. In he US he insananeous median esimae is slighly below 2.0 and consan across horizons; in he EA i is also slighly below 2.0 and decreasing wih he horizon; in he UK i is below 1.0 and increasing wih he horizon. However, since he mulipliers are imprecisely esimaed, we canno exclude wih high probabiliy ha hey are less han 1 a any horizon, for any of he hree counries Adding idenificaion resricions Since he paerns in figure 2 are quie robus o sandard specificaion changes analyzed in he lieraure (e.g., hey are robus o changes in he sample period, lag lengh and ransformaion of he variables enering he VAR, ec.), i could be concluded ha he daa are unable o provide clear conclusions regarding he relevance of he heory. However, raher han abandoning he invesigaion, we sudy wheher inference is sharpened wih he addiion of idenificaion resricions. Thus, in addiion o he consrains on he impac responses of governmen consumpion expendiure, defici and oupu growh, we resric also he impac response of he real wage, or he real rae, or he labor wedge, or all hree responses joinly. To ensure ha he ceeris paribus condiions roughly hold, we require he responses of bond yields o be also insananeously unchanged. Adding idenificaion resricions slices he response inervals of figure 2, eliminaing some scenarios. We wan o deermine wheher he daa could be consisen wih cerain consrains on real wage, real ineres rae, and he labor wedge and wheher hese resricions provide a beer measure of he oupu mulipliers.

17 Fiscal policy, pricing fricions and moneary accommodaion 17 Table 1 which repors he insananeous oupu per-capia muliplier obained in each exercise we conduc and he poserior credible 68 percen inervals in parenhesis, display some ineresing facs. Firs, imposing any of he hree resricions sharpens he inference considerably and enables a beer measuremen of he magniude of he mulipliers: he poserior inervals are much smaller in all cases. Second, including he resricion ha he real rae falls in response o governmen consumpion expendiure disurbances makes he median oupu muliplier for all counries large relaive o he average oupu muliplier. Thus, an accommodaive moneary policy is very imporan for expendiure expansions o be effecive. The gain is considerable in he case of he UK which was experiencing an inflaion argeing regime during he period considered. Third, resricing real wages o be posiive is insufficien o obain large insananeous per-capia oupu mulipliers. In fac, in our case, he mulipliers obained are he smalles and are in he ail of he average mulipliers disribuion. In oher words, increases in he real wage are necessary, bu by no mean sufficien o produce large oupu expansions. Fourh, imposing ha he labor-efficiency wedge falls, generaes differen resuls in differen counries: per-capia oupu mulipliers are larger in he US; bu in he EA and he UK hey are significanly below 1. There are wo poenial explanaions for his heerogeneiy. I could be ha, in he relevan region, nominal fricions are much more imporan for he US, making he slope of he Phillips curve much flaer. Alernaively, he marginal produc of labor reacs o changes in fiscal variables in he US, bu no in Europe, hus making i possible o produce a larger oupu a a given marginal cos. Finally, imposing ha all hree condiions are saisfied increases he magniude of per-capia oupu mulipliers in all counries. The gain is larges in he US; in he UK imposing all he resricions increases per-capia mulipliers only marginally relaive o he case where resricions are imposed only on he real rae. The numbers in he las column in able 1 are large based on he sandards in he lieraure (he range is [0.6, 1.0]) and underline he imporance of aking accoun of heoreical consideraions o obain meaningful empirical resuls. Differences in he naure of he hree economies accoun for he differences in he magniudes of he per-capia mulipliers across he rows in able 1. For example, he UK, which is much more open o rade han he EA or US, has uniformly smaller per-capia mulipliers han hese oher wo areas. However, oher idiosyncrasies seem o maer less. For example, consider labor marke insiuions: i is well known ha in he EA he real wage adjusmen o shocks is much slower han in he US due o he naure of labor marke arrangemens (especially he srengh of unions and he high replacemen coss in he former). Thus, one would expec ha imposing a fas response of he real wage o expendiure shocks (as i is done in he able 1, column 3) would make oupu mulipliers larger in he EA relaive o he oher wo counries. Clearly, his is no he case. Furhermore, as indicaed, for example, in Gali (1994), he larger he size of governmen, he sronger are he sabilizaion properies of expendiure shocks and, herefore, he

18 Fiscal policy, pricing fricions and moneary accommodaion 18 larger are he oupu mulipliers. On average, oupu mulipliers in he EA, which has he larges governmen size, and in he US, which has he smalles governmen size, are similar. Thus, when he heoreical condiions we highligh are saisfied, having a large public secor is irrelevan for explaining magniude differences. To summarize, sicky-price New Keynesian models appear o provide useful guidance o undersand he mechanisms leading o effecive fiscal expansions and when he condiions on he real rae, he real wage and he labor efficiency wedge are saisfied, expendiure increases may make oupu expansions large. Of he hree heoreical condiions idenified, accommodaive moneary policy appears he mos relevan. Cross counry differences in he magniude of per-capia oupu mulipliers are driven by he cyclicaliy of he labor wedge and rade openness. Oher hings being equal, he more open he counry and he less reacive he markup o cyclical condiions, he smaller will be he per-capia oupu muliplier generaed by an expendiure expansion Are he condiions of differen? I is ofen claimed in policy circles ha he curren condiions are differen from hose ha have prevailed in he pas on average. Many commenaors claim ha he curren recession is deeper han any oher pos WWII recession; ha he fiscal packages came afer an imporan financial crisis; ha hey were enaced a a ime when he abiliy of moneary policy o sabilize cyclical flucuaions was limied; and ha unprecedened global facors maer. To he exen ha he curren fiscal expansion is occurring in a ruly unique environmen, i is impossible o use pas daa o deermine is macroeconomic consequences. However, if episodes wih similar feaures could have occurred in he pas in he sense ha here was some probabiliy ha he curren condiions could have maerialized in he sample - we can sudy wheher he necessary condiions for fiscal effeciveness are more likely o hold in hese siuaions, and analyze wheher he percepion ha he magniude of he oupu muliplier is larger han in normal imes is correc or no. Given he lack of measures of financial ighness in he VAR and he linear framework we use, he scope of our exercise is limied. However, we can mimic wo imporan aspecs of he curren siuaion. Firs, we can analyze he dynamics of macroeconomic variables when he size of he consumpion expendiure shock (or he size of he defici) is large relaive o hisorical sandards and he nominal rae canno move in response o he shock. Second, we can sudy wheher consumpion expendiure shocks ha ake place in recessions, by which we mean expendiure shocks accompanied by a simulaneous fall in ax revenues and inflaion, are differen from hose recovered on average. To produce he firs se of circumsances, in addiion o resricions on he impac response of expendiure, defici and oupu growh, we impose he consrains ha he governmen expendiure o oupu raio (defici o oupu raio) increases on

19 Fiscal policy, pricing fricions and moneary accommodaion 19 impac by a leas 1 percen (0.5%) and ha he nominal rae is unchanged.. We also consider he scenario where he nominal ineres rae is fixed a zero raher han a he seady sae. Since his scenario has a negligible probabiliy o have maerialized in he pas, here is lile o learn from i for he curren siuaion. In he second case, we add he resricions ha ax revenues and he inflaion rae fall conemporaneously in response o he shock. Given ha resricions on he magniude of he impac response of he governmen expendiure o oupu or he defici o oupu raios produce qualiaively similar dynamics, we only repor resuls obained resricing he former. We summarize he consrains used in he hird and fourh columns in able 2. Figure 3 repors he responses of some variables of ineres in he large spending scenario; Figure 4 repors similar responses for he recessions scenario. In boh figures, he rows correspond respecively o he US, he EA and he UK. The las rows of able 1 summarize he magniude of he impac oupu mulipliers in hese wo scenarios. The occurrence of large expendiure shocks when he nominal rae is fixed resuls in real rae falls of roughly he same amoun in all counries. The paern of responses of he oher wo variables is heerogeneous: he real wage falls in he US and UK, and increases in he EA; he labor efficiency wedge increases in he US and in he EA, and falls in he UK. Per-capia oupu mulipliers are roughly similar in size and significanly less han 1 in he EA and he UK; in he US hey are abou hree imes larger and significanly above 1, a leas on impac. Thus, in his scenario, he dynamics of he real wage, he real rae and he labor efficiency wedge do no fully deermine he magniude of he oupu effecs of he expendiure expansion. Since in all counries he real ineres rae falls by roughly he same amoun, i is highly unlikely ha differences in he way he IS curve shifs, are responsible for he cross counry differences observed. In a recession, unexpeced increases in governmen spending drive up he real rae in all counries while he response of he oher wo variables is heerogeneous: he real wage increases in he US and he EA, and decreases in he UK; he efficiency wedge increases in he US and he UK and decreases in he EA. Ineresingly, in his scenario, moneary policy is igh in all counries - in he US and he EA he nominal rae falls bu less han inflaion, in he UK i increases despie he decrease in inflaion and his igh moneary policy could be responsible for he modes per-capia oupu mulipliers we obain. The slighly larger per-capia oupu mulipliers in he EA appear o be due o he real wage responses, which are considerably larger han in he oher counries. Comparing he rows in figures 3 and 4, we can see ha alhough he wo scenarios are designed o capure aspecs of he curren siuaion, hey have differen implicaions for he real wage, he real rae and he labor efficiency wedge. Noe also ha, alhough he real rae responds negaively in figure 3 and posiively in figure 4, per-capia mulipliers are no uniformly larger in he large expendiure scenario. Thus, o undersand he paern we obain, we need o consider he dynamics of oher variables.

20 Fiscal policy, pricing fricions and moneary accommodaion 20 Three imporan conclusions can be drawn from he evidence repored in his subsecion. Per-capia oupu mulipliers generaed in siuaions similar o hose prevailing in are unlikely o be larger han hose obained on average in he pas, primarily because he condiions for fiscal expansions o be effecive are eiher no applicable or no necessary in hese scenarios. Also, i is unclear which of he condiions characerizing he curren siuaions maers more in he US he per-capia muliplier is larger when he size of he shocks is large and he nominal rae is unchanged, bu is larger in he EA when a recession is ongoing. Ineresingly, he role of fiscal policy in he US during a recession is small: he per-capia oupu muliplier produced is among he smalles we obained. This conclusion should be compared wih hose of Auerbach and Gorodnichenko (2010), who employ a differen echnique and find ha fiscal policy has quie differen effecs in recessions and expansions. Perhaps mos ineresing is he paern of responses obained, which is somewha difficul o explain wihin he New Keynesian paradigm. For example, in he EA, an accommodaive moneary policy is insufficien o produce large oupu expansions, and he condiions ha would make he aggregae supply curve flaer are generally violaed. Wha hen is driving hese resuls? One possibiliy is ha some of he ceeris paribus condiions do no hold in some of hese scenarios or may hold in some scenarios, for some counries bu no ohers. Anoher possibiliy is ha he New Keynesian framework we used as our organizing principle o inerpre he evidence canno accoun for he exreme evens we consider. In he nex subsecion we invesigae which hypohesis is likely o be rue The effecs on deb and inflaion An imporan par of he public debae following he exraordinary fiscal packages legislaed in 2009, has o do wih he size of he deb, he increased percepion of defaul and he inflaion effecs produced. Many commenaors believed ha he legislaion would generae explosive deb dynamics, and financial markes agreed and reaced in 2010 and 2011 by increasing he spread beween counries bond yields and poenially unsusainable deb. On he oher hand, many policy-makers believed ha he fiscal packages would no impair susainabiliy of he deb if hey could generae sufficien oupu expansion and some inflaion, which in urn would produce an imporan side effec. Higher inflaion would provide he cenral banks wih room for maneuver, he radiional moneary policy insrumen, bu a possibiliy ha rereaed when nominal ineres raes reached he zero bound. In his subsecion, we examine he deb and inflaion dynamics induced by expansionary defici-financed consumpion expendiure disurbances in he wo scenarios previously considered. The fifh and sixh columns in figures 3 and 4 show he responses of he deb o oupu raio, and of inflaion o he shocks; again, he firs row refers o he US, he second o he EA and he hird o he

21 Fiscal policy, pricing fricions and moneary accommodaion 21 UK. Since governmen deb is no a variable in he VAR, we consruc deb o oupu dynamic responses using a budge consrain ideniy, as in Favero and Giavazzi (2007), assuming ha a ime zero he deb o oupu raio is a he seady sae, ha one-period real bonds are used o finance he defici and ha no correcive measures are aken a any fuure horizon. Thus, he deb o oupu dynamics we presen are hose ha would obain if governmen compleely disregarded he effecs of a emporary shock on consumpion expendiure for fuure deb, and expecaions were consan. In he US, shocks ha increase expendiure by large amouns when he nominal rae is unchanged, leave he deb o oupu raio unchanged in he shor run and decrease i in he medium run. Afer eigh quarers, one could expec a median fall of abou 1 percen from he seady sae level. Our calculaions sugges ha if he shock lass for six quarers raher han one, he deb o oupu raio effec a he eigh quarers horizon would be roughly five imes larger (in absolue value). Thus, he fac ha shocks are large does no necessarily induce unconrolled deb dynamics. There are wo explanaions for his resul: he fall in he real rae reduces he service coss of he deb; he oupu increase produces a significan increase in ax revenues. Given ha he nominal rae is insananeously fixed and ha he real rae falls, large expendiure shocks emporarily increase inflaion. The response of he deb o oupu raio in a recession is significanly posiive and somewha larger in size since he real rae increases and ax revenues fall. In he median, a defici financed governmen consumpion expansion adds wo percenage poins o he deb o oupu raio afer eigh quarers. Aferwards, he effec becomes insignifican. In he EA, he deb o oupu raio increases modesly bu significanly in boh scenarios. Quaniaively, i is expeced o increase by abou one percenage poin afer eigh quarers and o reach is new seady sae of abou 2 percen higher afer five years. As in he US, he inflaion rae increases wih large spending shocks, bu he effec is shor lived. In he UK, large expendiure shocks occurring when he nominal rae is insananeously unchanged induce deb and inflaion dynamics similar o he EA: deb o GDP is posiive, i reaches a new seady sae abou 2 percen higher afer 4.5 years, and inflaion emporarily increases. Since he magniudes of he changes in he real rae, in oupu per-capia and in ax revenues are similar, he magniude of he changes in he deb o GDP raio and inflaion in he EA and he UK are also similar. However, conrary o he US, ax revenues o GDP fall in he EA and UK in boh scenarios. To undersand why he resuls do no conform o he predicions of he class of New Keynesian models, we consider i useful o sudy why he dynamics of inflaion differ in hese wo scenarios. The las wo columns of figures 3 and 4 show he dynamics of yield on long erm governmen bonds and of he consumpion o oupu raio. Recall ha when

22 Fiscal policy, pricing fricions and moneary accommodaion 22 deriving our heoreical predicions, we assumed implicily ha he responses of long erm yields are negligible. In pracice, his appears no o be he case. In he large expendiure scenario he yield on long erm governmen bonds increases in he US and he EA and decreases in he UK; in he recession scenario i increases in he EA and falls in he US and UK. Thus, eiher long erm inflaion expecaions or long erm oupu expecaions, or boh change following an unexpeced increase in governmen expendiure. Also, while in he EA and he UK he sign of he responses is he same in boh scenarios, in he US he sign changes and his could explain he dynamics of he real rae, he real wage and of he per-capia muliplier in he wo scenarios. In general, he aggregae supply curve appears o shif when aggregae demand moves, making he oucome of fiscal expansion somewha unpredicable. Per-capia consumpion increases in boh scenarios, in he US and UK, shown by summing he responses in columns eigh and four in each figure. However, he consumpion o oupu raio falls in he US, he EA and he UK. Thus, he sensiiviy of consumpion o curren income decreases in response o he shock. If agens are more pruden in heir spending, or lose confidence in he fuure evoluion of he economy in hese siuaions, savings may increase or dissavings may fall when oupu increases. There is pleny of evidence ha consumers adop more pruden spending habis in recessions or when he economic environmen is less favorable. Hence, an increase in governmen spending in hese scenarios no only shifs he aggregae demand curve, bu also changes is slope and may even wis i backward if he invesmen o oupu raio is similarly affeced. In sum, expansionary expendiure shocks occurring in scenarios ha mimic he curren siuaion induce only modes deb o oupu raio dynamics. The magniude of he responses is counry and sae dependen and he signs of he revenue responses shape boh heir magniude and heir sign. The inflaion effecs of large expansionary shocks are emporary and similar across counries. Thus, while in heory fiscal expansions may give moneary policy some lever o move nominal raes, in pracice his remains wishful hinking. Finally, in he wo scenarios we consider, increases in governmen spending no only shif he aggregae demand curve bu also wis i and aler he aggregae supply locus, making he condiions on he real wage, he real rae and he labor efficiency wedge neiher necessary nor sufficien for effecive fiscal expansions Consolidaion schemes The ensions in he markes for sovereign deb since 2009 have refocused public aenion on he quesion of he susainabiliy of public deb and he need for fiscal consolidaion schemes driving deb back o manageable levels. We have seen ha fears abou unconrolled deb dynamics have no srong empirical foundaion. Neverheless, i

23 Fiscal policy, pricing fricions and moneary accommodaion 23 is useful o analyze consolidaion schemes since his migh shed imporan ligh on he naure of he adjusmens occurring in hese siuaions. Since he sudy by Giavazzi and Pagano (1990), he folk wisdom in he profession is ha consolidaion schemes could be expansionary. The underlying idea is ha by creaing expecaions of a permanenly sounder policy sance, agens may be induced o expand privae spending by more han he fall in governmen absorpion (for a review, see Alesina and Ardagna, 2009). Afonso (2010) shows ha effecs of his ype were presen in he EA when consolidaion schemes considerably reduced he real rae of ineres and hus deb financing coss. Coenen e al. (2008), on he oher hand, using he esimaed ECB new-area wide model, show ha fiscal consolidaions are always conracionary in he shor run, a conclusion confirmed by Forni e al. (2010). A variey of opinions abou he macroeconomic consequences of consolidaion schemes coexis in he policy arena and, following he G-20 meeing in summer 2010, for example, many US officials believed ha he measures adoped by he EA would lead o a new grea depression cuing expendiure when economic aciviy had no recovered would be worse han no acion a all. Our empirical model allows us o consider wo consolidaion schemes discussed in he lieraure: curren expendiure expansions accompanied by fuure expendiure cus (he so-called spending reversals); curren expendiure expansions accompanied by fuure defici cus (achieved hrough fuure expendiure cus or fuure revenue increases). Corsei e al. (2009) claim ha, oher hings being equal, spending reversals can make oupu mulipliers larger by signaling o agens he emporary naure of he measures and he commimen of governmen o reurn o he fiscal orhodoxy as soon as he negaive circumsances requiring he simulus are removed. Uhlig (2010), however, warns agains defici consolidaion schemes carried ou oo rapidly, since expecaions abou fuure increases disoring axaion may make oupu mulipliers negaive. Canova and Pappa (2006) show ha unexpeced expendiure increases, rapidly mached by increases in disoring ax revenues, hisorically have had large and negaive effecs in US saes required by consiuion or legislaion o balance heir budges a he end of he fiscal cycle. The las wo columns in able 2 display he idenificaion resricions used in hese wo scenarios and figures 5 and 6 show he dynamic responses of he variables of ineres: he firs, second and hird rows in he figures refer respecively o he US, he EA and he UK. We presen expendiure schemes reversed afer wo quarers, bu he resuls are qualiaively unchanged if he reversal is expeced o ake place four periods afer he iniial governmen consumpion expendiure shock occurs. More imporanly for inerpreaion purposes, he spending reversal and he defici consolidaion programs are assumed o be known o agens when governmen consumpion expendiure unexpecedly increases.

24 Fiscal policy, pricing fricions and moneary accommodaion 24 Governmen expendiure reversal schemes induce posiive real wage response and negaive labor efficiency wedge responses in all counries. However, while he real rae decreases in he EA, i increases in he US and he UK. Per-capia oupu mulipliers are only slighly above one in he US and he UK, and considerably above ha in he EA. Thus, in his scenario oo, he dynamics of he real rae are crucial o deermine he magniude of he real effecs of governmen spending shocks. Noe ha inflaion falls in he US and he UK, bu increases srongly in he EA, and moneary policy significanly deviaes from he Taylor principle in his scenario: in he US he nominal ineres rae is roughly unchanged when inflaion falls; in he EA he nominal ineres rae is also unchanged despie he increase in inflaion; in he UK a fall in inflaion is accompanied by a fall of a smaller magniude in he nominal rae. To undersand why he dynamics of inflaion differ in he US, EA and UK, i is worh examining he behavior of long erm governmen bond yields, which in his scenario provide informaion abou long erm inflaion expecaions. In he UK, inflaion falls because he program shifs boh aggregae demand and he aggregae supply curve. As already menioned, he aggregae supply curve depends on expeced fuure inflaion. Since he reversal scheme reduces long erm inflaion expecaions, i moves he aggregae supply curve o he righ and he combined shif in aggregae demand and he aggregae supply schedules cause curren inflaion o fall. In he EA, he shif in he aggregae demand curve is accompanied insead by an increase in long erm inflaion expecaions. Thus, heaggregae supply shifs inward creaing considerable inflaion. The US paern is difficul o inerpre since inflaion falls and long erm inflaion expecaions increase. One explanaion migh be ha he reversal is perceived as emporary, making aggregae supply move ouward emporarily, and hen overshoo inward over he long run. Alernaively, he shock may aler he seady sae markup, for example, causing he aggregae supply curve o roae. The dynamics of he privae consumpion o oupu raio are useful o inerpre he resuls. Recall ha his variable ells us wheher he sensiiviy of consumpion o income changes wih he policy and he scenario considered, and how he IS curve shifs in response o expendiure increases. The response of he consumpion o oupu raio is qualiaively similar across counries: i falls insananeously hen slowly reurns o is seady sae. However, he magniude of he changes is considerably larger in he EA. Thus, following governmen expendiure shocks ha are expeced o be reversed in he near fuure, consumers ac in a more neoclassical and less Keynesian manner, in he sense ha he sensiiviy of consumpion o curren income falls, making he dynamics of he real ineres rae more relevan for consumpion expendiures han on average. Since he real rae falls in he EA and increases in he US and he UK, he EA muliplier is almos hree imes larger han in he oher wo regions.

25 Fiscal policy, pricing fricions and moneary accommodaion 25 The consolidaion scenario presens similar feaures. Unexpeced increases in governmen consumpion expendiure known o produce defici reducions in he fuure, increase he real wage and decrease he labor efficiency wedge, while he real ineres rae responds posiively in he US and UK and negaively in he EA, alhough he effec in he EA is quie emporary. The magniude of he per-capia oupu mulipliers in he wo scenarios is roughly similar for he US; for he EA i is slighly larger in he consolidaion scenario, primarily because of he larger responses of he real wage and he efficiency wedge; and i is larger in he UK in he consolidaion scenario. Given ha he dynamics of inflaion and long erm inflaion expecaions are similar in he wo programs, he differences in he magniude of he UK per-capia muliplier mus be due o differen consumer responses in he consolidaion scenario. The las column in figure 6 shows ha, indeed, he privae consumpion o oupu raio sharply increases (i falls in he reversal scenario, see figure 5). Thus, consumer spending becomes more Keynesian boosing oupu more in he consolidaion scenario. Wha have we learned from hese wo exercises? Neiher Uhlig s (2010) pessimisic view abou deb consolidaion programs nor Corsei e al. s (2009) opimisic view abou spending reversals is fully suppored by he daa. There is some evidence ha well designed and well undersood, reversible expansionary expendiure schemes could lead o oupu expansions larger han hose obained wih an expansionary expendiure scheme ha is no expeced o be reversed in he fuure. However, for his o happen one of wo condiions needs o be saisfied. A consolidaion program ha is accompanied by a fall in he real rae of ineres has more chance of being oupu effecive in he shor run. Similarly, given a real rae response, a consolidaion program ha alers he sensiiviy of consumpion expendiure o income may deliver larger oupu mulipliers. Thus, regardless of he deail of he conainmen scheme, he shor run effeciveness of fiscal expansions depends on wha moneary policy does and wha agens perceive he fuure will bring in erms of oupu and inflaion. 5. Conclusions Wha conclusions can be drawn from our sudy? Firs, he class of sicky-price New Keynesian models popular in academic and policy circles, in normal imes, provides useful guidance o undersand he mechanisms leading o effecive fiscal expansion. The condiions idenified by he heory as necessary o deliver large oupu effecs have differen imporance in pracice: how moneary policy responds o fiscal expansion is crucial; he sensiiviy of real wages o demand condiions appears o be minor. If he hree condiions are saisfied, per-capia mulipliers can be large in absolue erms and larger han he average esimaed in he lieraure. Cross counry differences can be relaed o he cyclicaliy of he markup and o rade openness. Oher hings being equal, he more open he counry and he less reacive he markup o cyclical condiions, he smaller will be he per-capia oupu muliplier generaed by a given expendiure

26 Fiscal policy, pricing fricions and moneary accommodaion 26 expansion. The size of he governmen secor or he exen of labor marke regulaion seems o be much less imporan in accouning for cross counry differences in per-capia oupu mulipliers. Second, per-capia oupu mulipliers generaed in siuaions such as hose prevailing in are unlikely o be larger han hose obained on average in he pas. Our conclusions differ from hose provided by previous sudies because, hisorically, in he scenarios we consider, he ceeris paribus assumpions are unlikely o hold, making he condiions for he effeciveness of fiscal expansions eiher inapplicable or less necessary. In paricular, expecaions urn ou o be subsanially affeced and parameers, which ypically are regarded as srucural, may insead be sae dependen. To fully undersand he implicaions of fiscal expansions in siuaions of deep economic crisis we need a more complex model. Noe also, ha he scenarios we consider may no be capuring well he fac ha he nominal ineres rae is suck a zero, because he probabiliy ha his happened in he pas is negligible. Thus, exrapolaion of he implicaions of our analysis should be made wih care. While per-capia oupu mulipliers are unlikely o be large, here are differences in he abiliy of fiscal policy o affec oupu in differen counries and differen condiions. Explaining hese heerogeneiies requires deailed analysis of he srucural differences in he hree economies, displayed in hese scenarios, which is beyond he scope of his paper. In general, he cross counry variaions we deec indicae he need for cauion in using he predicions of he class of models we consider in special condiions, no only because hese condiions are ouside he norm, bu also because differen counries may reac differenly o he same fiscal impulses. Third, he deb consequences of he expendiure programs we consider are small. Thus, neiher he fac ha he curren packages are large as a percenage of oupu, nor he fac ha oupu growh is currenly low, appears o hreaen fiscal susainabiliy in he US, he EA or he UK. Our calculaions are condiional on fuure expecaions being roughly consan. However, even if we consider shifs in expecaions consisen wih he dynamics of governmen bond yields, deb effecs appear o be limied. To jusify he recen pressures in he bond markes, expecaions would need o have shifed considerably more han in he pas in response o he expansion. To analyze he consequences of fiscal expansions when considerable swings in he fuure percepions of he sae of he economy are possible, requires an alernaive heoreical framework, in which expecaions may no necessarily be raional. Sudying he implicaions of spending shocks in hese frameworks is ineresing, bu beyond he scope of he curren paper. Fourh, he expendiure increases conemplaed for 2009 and 2010 are unlikely o lead o significan and persisen increases in inflaion. Thus, i is highly improbable ha fiscal policy will liberae moneary policy from he zero nominal ineres rae rap. However, since changes in fiscal policy may have sae dependen effecs on he privae secor,

27 Fiscal policy, pricing fricions and moneary accommodaion 27 oher channels no considered in his analysis migh affec our conclusions. Fifh, expendiure expansions accompanied by well designed fuure defici reducion schemes may lead o shor run oupu expansions ha are larger han hose obained wih expendiure expansions which are no expeced o be correced in he fuure. For his o occur, however, moneary policy needs o be accommodaive and he policy needs o be credible in he sense ha fuure inflaion expecaions will be unchanged. When moneary policy is resricive, consolidaion policies ha make consumers care more abou curren and less abou fuure income have he poenial o produce large shor run oupu expansions. The deails of he consolidaion scheme as well as is iming appear o be less crucial for deermining he qualiy of he oucome; wha does appear o maer is ha he policy is well undersood and he commimen o reurn o he fiscal orhodoxy is solid. Our resuls generally sress ha fiscal policy could be an effecive counercyclical ool and ha he oupu mulipliers i generaes may be significanly larger han 1. For his o happen, moneary policy should faciliae fiscal expansion; expecaions abou fuure oupu growh and inflaion should no be affeced; and srucural relaionships, such as he sensiiviy of consumpion o oupu or he real ineres rae, should be invarian o he policy change. Appendix A: A prooypical New Keynesian model The model we presen is a simplified version of he one considered in Pappa (2009) and illusraes he ypical predicions of New Keynesian models regarding he effecs of defici financed governmen expendiure shocks on macroeconomic variables. The preferences of represenaive consumers are represened by he uiliy funcion 1 σ 1+ φ C N E 0 β χ = 0 1 σ 1 + φ where C is privae consumpion, N is hours worked, σ>0 is he consan relaive risk aversion coefficien, φ>0 is he inverse of he Frisch labour supply elasiciy, 0<β<1 is he discoun facor, χ>0 is a consan and E o is he expecaion operaor, condiional on ime zero informaion. Consumers maximize heir lifeime uiliy choosing sequences for

28 Fiscal policy, pricing fricions and moneary accommodaion 28 privae consumpion, invesmen, hours worked, and bond holdings, aking as given prices and ax raes, subjec o he sequence of budge consrains P 1 ( C + I ) + R B + 1 (1 τ )( P w N + ( r δ ) P K ) + B + Ξ T P and he law of moion of capial K + 1 K I K v + 1 = + ( 1 δ ) K K where P is he price level, I is invesmen, B are one period nominal bonds, R is he nominal ineres rae, w is he real wage, r he renal rae of capial, T are lump sum ransfers, Ξ are profis from owing he inermediae goods firms, τ is he income ax rae, δ is he capial depreciaion rae and ν conrols he (quadraic) coss of adjusing capial. In he producion secor, here is a compeiive firm assembling inermediae goods ino a final good using he following consan-reurns-o-scale echnology: Y where ε > 1 is he consan elasiciy of demand for inermediae goods, Y is final oupu and Y (j) is he oupu of inermediae good j. The final good can be used for privae and governmen consumpion and invesmen, i.e. Y = C + I + G. There is a coninuum of firms producing inermediae goods. Each inermediae firm j produces oupu according o he echnology: Y (j) = (A j N (j)) 1-α K (j) α where A j is a echnological disurbance and α he share of capial. These firms are compeiive in he inpu markes and minimize coss by choosing privae inpus, aking wages and he renal rae of capial as given. Since firms are idenical, hey all choose he same amoun of inpus. Cos minimizaion implies ha relaive facor prices deermine he relaive use of capial and labor and ha he common real marginal coss are: 1 α 1 α mc 1 = Y 0 = α α (1 α ) r 1 α In he oupu marke inermediae firms are monopolisic compeiors. The sraegy firms use o se prices depends on wheher prices are flexible or sicky. In he laer case he probabiliy for an inermediae good producer o rese is price is se equal o (1-γ). When a producer receives a signal o change is price, i chooses a new price o maximize expeced profis. The soluion o he profi-maximizing problem produces: ( j ) E Q * ε j = 0 P = ε 1 E, + j j = 0 Q γ j, + j w i i [ mc Y ] j γ Y where Q,+j is he shareholder s discoun facor (he marginal uiliy of one uni of nominal profis j periods from now) and he aggregae price index evolves according o: ε 1 ε dj ε ε 1 + j i + j + j P 1 1 ε *1 ε [ γp + 1 γ P ] ε = 1 1 ( )

29 Fiscal policy, pricing fricions and moneary accommodaion 29 When prices are flexible he fracion of firms ha can rese heir prices a each is equal o 1 (γ=0) and prices are se as a consan mark-up over marginal coss * ε P = mc ε 1 Governmen income consiss of ax receips and he proceeds from new deb issue; expendiures consis of consumpion purchases and repaymen of deb. The governmen budge consrain is: 1 R B + 1 = PG + B T P τ ( Pw N P ( r δ ) K ) There is an independen moneary auhoriy seing he nominal ineres rae as: R R = R + ζ π π + q where ζ a feedback parameer and π π he inflaion rae. There are several opions for closing he model. The firs is o assume a balanced budge in each period (i.e. B =0 for all ) and he absence of disoring axaion (τ=0). Alernaively, one could balance he budge using disoring ax revenues and le T =0 for all. If deb is allowed, one has he opion o le he deb grow wihou limis or use a deb argeing rule of he form: T = T exp( ζ ( B B)) where T is a consan, B is some arge level of deb and ζ a feedback parameer. When b only disoring axes are available, he rule becomes: τ = τ exp( ζ ( B)) Pappa (2009) shows ha expansionary governmen consumpion expendiure shocks financed by bond creaion induce robus impac responses for G (i increases), he defici G - T (i increases), and oupu growh Y (i increases) when he parameers (σ, χ, φ, υ, δ, ε, α, γ, ζ, π ζ ) are allowed o vary wihin a reasonable range. b To highligh he differences beween he New Keynesian and he neoclassical versions of he model we assume ha (β=0.99, σ=1, χ=1, φ=2, υ=2, δ=0.25, ε=7, α=0.3, ζ =1.5, π ζ =0.2, τ=0) and simulae he responses of consumpion, invesmen, real b wage, he real rae, hours and oupu when an impulse in governmen expendiure shock lass one period in he log-linearized model soluion. The op panel in Figure A1 presens he responses when γ=0.75; he boom panel he responses when γ=0. b b B Responses o one s.d. governmen consumpion shock 0.1 real rae Percen deviaion from seady sae 0.08 labor 0.06 oupu real wage 0 consumpion invesmen Years afer shock

30 Fiscal policy, pricing fricions and moneary accommodaion 30 Percen deviaion from seady sae 0.06 labor 0.04 oupu real rae consumpion real wage invesmen Responses o one s.d. govermen consumpion shock Years afer shock Figure A1: Responses o a governmen consumpion spending impulse. Top panel New Keynesian model; boom panel RBC model. Appendix B: Daa Consrucion Acronyms: BEA: Bureau of Economic Analysis, Naional Income and produc Accouns; BLS: Bureau of Labor Saisics, FRED: Fed of S. Louis, IFS: Inernaional Finance Saisics, OECD: Organizaion of Economic Cooperaion and Developmen. US: 1) Raio of consumpion expendiure o GDP: nominal consumpion expendiure (BEA A955RC1) divided by real GDP (BEA A191RX1) imes GDP deflaor (BEA B191RG3). 2) Raio of oal ax receips o GDP: oal nominal receips (BEA W066RC1) divided by real GDP (BEA A191RX1) imes GDP deflaor (BEA B191RG3). 3) Growh rae of real GDP per-capia: Firs difference of he log of real GDP (BEA A191RX1) divided by working age populaion 16 o 65 (FRED POP16OV), annualized. 4) Growh rae of real wages: firs difference of he log of Nonfarm Business Secor Nominal Compensaion per Hour (BLS COMPNFB) divided by he GDP deflaor (BEA B191RG3), annualized in percenages. 5) Real ineres rae: nominal 3-Monh Treasury bill ( Secondary Marke Rae (FRED TB3MS)) minus he annualized firs difference of he log of GDP deflaor (BEA B191RG3). 6) Profi rae: 1 minus he produc of oal non-farm employmen rae (FRED CES ) imes Nonfarm Business Secor Nominal Compensaion per Hour (BLS COMPNFB) divided by nominal GDP (BEA A191RC1)

31 Fiscal policy, pricing fricions and moneary accommodaion 31 7) Inflaion rae: annualized firs difference of he log of GDP deflaor (BEA B191RG3). 8) Long erm yields: average yield on 10 year bonds (IMS) 9) Raio of privae consumpion expendiure o GDP: real personal consumpion expendiure (FRED PCECC96) o real GDP (FRED GDPC96), 3-digi chained dollars. EU (1)-7) and 9) from he AW9 daabase): 1) Raio of consumpion expendiure o GDP: nominal governmen consumpion expendiure o nominal GDP. 2) Raio of oal ax receips o GDP: oal nominal governmen revenues o nominal GDP. 3) Growh rae of real GDP per-capia: Firs difference of he log of real GDP, scaled by he labor force, annualized. 4) Growh rae of real wages: firs difference of he log of he nominal wage per head scaled by he GDP deflaor, annualized. 5) Real ineres rae: nominal shor erm ineres rae minus he annualized firs difference of he log of GDP deflaor 6) Profi rae: 1 minus he produc of nominal wage per head and number of persons employed, scaled by nominal GDP. 7) Inflaion rae: firs difference of he log of GDP deflaor annualized. 8) Long erm yields: average yield on 10 year bonds (IFS) 9) Toal real privae consumpion expendiure divided by real GDP UK: 1) Raio of consumpion expendiure o GDP: nominal seasonally adjused consumpion expendiure (from he IFS) divided by nominal seasonally adjused GDP (from he IFS). 2) Raio of oal ax receips o GDP: sum of seasonally adjused direc and indirec axes (from he OECD) divided by nominal GDP (from he IFS). 3) Growh rae of real GDP per-capia: Firs difference of he log of nominal GDP (from he IFS) divided by he GDP deflaor and oal populaion (boh from IFS), annualized. 4) Growh rae of real wages: firs difference of he log of nominal employee compensaion (AR) CURA (from he OECD) divided by he seasonally adjused GDP deflaor (from he IFS), annualized. 5) Real ineres rae: nominal 3-Monh Treasury bill rae (from he IFS) minus he firs annualized difference of he log of GDP deflaor (from he IFS). 6) Profi rae: 1 minus he produc of real employee compensaion (AR) CURA (from he OECD) and number of employed (from IFS) scaled by real GDP (from IFS). 7) Inflaion rae: firs difference of he log of GDP deflaor (from IFS) annualized. 8) Long erm yields: average yield on 10 year bonds (from IFS)

32 Fiscal policy, pricing fricions and moneary accommodaion 32 9) Raio of consumpion o GDP: Real privae consumpion expendiure o real GDP (boh from IFS). Appendix C: The Bayesian prior and he algorihm o idenify shocks. The prior we use assumes ha he VAR coefficiens are random and ha he covariance marix of he shocks is fixed. Leing A denoe he vecorized version of he VAR coefficiens, we assume ha A is normal wih mean M and covariance S where M is he vecor of zeros excep for he firs own lag of he variables enering in logs (i.e. G/Y, T/Y, R, Profi, Inflaion). The marix S depends on four hyperparameers: s(1) regulaes he general ighness; s(2) he imporance of lags of oher variables in one equaion; s(3) he ighness of he consan erm; s(4) he lag decay. Values for s are obained using a simple grid search and maximizing he in-sample predicive power of he model over a raining sample preceding he esimaion sample and he inerpreabiliy of he resuls for each counry. For he US s=[0.0005, 0.5, 0.1,2], for he EU and he UK s=[0.0001, 0.1, 0.1,2]. Poserior esimaes are obained combining sample and prior informaion using a Theil-mixed ype esimaor see Canova (2007) for deails. The poserior disribuion of A, denoed by P(A), is normal and is momens combine sample and prior informaion wih weighs given by he relaive precision of he wo ypes of informaion. Given P(A), we draw vecors A(1),.A(m) using Mone Carlo mehods. Governmen expendiure shocks are idenified as follows. Le HH =I, and le Q(j, k) be he response marix a horizon j produced by he orhogonal decomposiion of he covariance marix of he shocks obained wih he k-h draw of A and le Q(1,j,k) he response vecor for he k-h draw produced a horizon j by he firs orhogonal shock. We compue R(j,k)=Q(j,k)H and check wheher he signs of R(1,j,k) for he appropriae variables are correc. If hey are, R(1, j, k) is sored, if hey are no he impulse responses are ossed. To generae H, we draw n imes n random normal marices wih zero mean and uni variance, perform a QR decomposiion and, for each draw, selec H=Q. References Afonso, A. (2010). Expansionary fiscal consolidaions in Europe: New evidence, Applied Economic Leers, 17, Alesina, A. and Ardagna, S. (2009) Large changes in fiscal policy: axes vs. spending, NBER working paper 15438, forhcoming Tax Policy and he Economy. Auerbach A. and Y. Gorodnichenko (2010). Measuring he oupu response of fiscal shocks, NBER Working Paper 16311, NBER, Cambridge, Ma. Barro R. and C. Redlick (2009). The macroeconomic effecs of Governmen Purchases and Taxes, NBER Working Paper 15369, NBER, Cambridge, Ma, forhcoming, Quarerly Journal of Economics. Baxer, M. and R. King (1993). Fiscal Policy in general equilibrium, American

33 Fiscal policy, pricing fricions and moneary accommodaion 33 Economic Review, 83, Blanchard, O. and R. Peroi (2002). An empirical characerizaion of he dynamic effec of changes in governmen spending and axes on oupu, Quarerly Journal of Economics, 117, Bouakez H. and N. Rebei (2007). Why does governmen consumpion raise afer a spending shock, Canadian Journal of Economics, 40, Burnside, C., Eichenbaum, M. and J. Fisher (2004). Fiscal shocks and heir consequences, Journal of Economic Theory, 115, Caldara, D. and C. Kamps (2008). Wha are he effecs of fiscal shocks? A VARbased comparaive analysis, European Cenral Bank Working Paper 877, ECB, Frankfur, Germany. Canova, F. (2007) Mehods for Applied Macroeconomic Research, Princeon Universiy Press, Princeon, NJ. Canova, F. and E. Pappa (2006). Does i coss o be viruous? The macroeconomic effecs of fiscal expansions, in R. Clarida, J. Frankel, F. Giavazzi and K. Wes (eds.), NBER Inernaional Seminar in Macroeconomics, 11-65, MIT Press, Cambridge, Ma. Canova, F. and E. Pappa (2011), Unpredicable and predicable governmen expendiure shocks,upf and UAB manuscrip. Chrisiano, L., Eichenbaum, M. and S. Rebelo (2009). When is he governmen spending muliplier large?, NBER Working Paper 15394, NBER, Cambridge, Ma. Coenen, G., Morh, M. and R. Sraub (2008). Fiscal consolidaion in he Euro Area: Long run benefis and shor run coss, Economic Modeling, 25, Coenen, G., Erceg, C., Freedman, C., Furceri, D., Kumhof, M., Lalonde, R., Laxon, D., Lindé, J., Mourougane, A., Muir, D., Mursula, S., de Resende, C., Robers, J., Roeger, W., Snudden, S., Traband, M. and J. Veld (2010). Effecs of fiscal simulus in srucural models, IMF Working Paper 10-73, IMF, Washingon, DC. Cogan, J., T. Cwik, J. Taylor and V. Wrieland (2010). New Keynesian version old Keynesian governmen spending mulipliers, Journal of Economic Dynamics and Conrol, 34, Corsei, G. and G. Muller (2006). Budge deficis and he curren accoun. Openness and he fiscal persisence, Economic Policy, Ocober, Corsei, G., Meier, A. and G. Muller (2009). Fiscal Simulus wih spending reversals, IMF Working Paper 09/106, IMF, Washingon, DC. Cwik, T. and W. Wieland (2009). Keynesian Governmen Spending Mulipliers and spillovers in he Euro Area, Cener for Financial Sudies Working Paper , CFS, Frankfur, Germany. Deveraux, M., Head, A., and B. Lapham (1996). Monopolisic compeiion, increasing reurns and he effecs of governmen spending, Journal of Money Credi and Banking, 28, Erceg, C. and Lindé, J. (2010). Is here a fiscal free lunch in a liquidiy rap, Board of Governors of he Federal Reserve Sysem, manuscrip. Favero, C. and F. Giavazzi (2007). Deb and he Effecs of Fiscal Policy, Bocconi

34 Fiscal policy, pricing fricions and moneary accommodaion 34 Universiy, manuscrip. Forni, L., Monefore, L., and L. Sessa (2009). The general equilibrium effecs of fiscal policy: esimaes for he Euro Area, Journal of Public Economics, 93, Forni, L., Gerali, A., and M. Pisani (2010). The macroeconomic effecs of fiscal consolidaions in Euro Area counries, Journal of Economic Dynamics and Conrol, 34, Galì, J. (1994). Governmen size and macroeconomic sabiliy, European Economic Review, 38, Galì, J., Lopez-Salido, D., and J. Valles (2007). Undersanding he effecs of governmen spending on consumpion, Journal of he European Economic Associaion 5, Giavazzi, F. and M. Pagano (1990). Can severe conracions be expansionary? Two ales of small European counries, in Blanchard, O. and Fisher, S. (eds.) NBER Macroeconomic Annual, , MIT Press, Cambridge, Ma. Giuliadori, M. and R. Beesma, (2008) On he relaionship beween Fiscal Plans in he European Union: an empirical analysis based on read-ime daa, Journal of Comparaive Economics, 36, Hall, R. (2009). By how much does GDP rise if he Governmen buys more oupu? Brookings Papers on Economic Aciviy, 2, Hall, R. (2011). The Long Slump, NBER working paper Kirchner, M., Cimadomo, J., and S. Haupmeier (2010). The ransmission of governmen spending shocks in he Euro area, Tinbergen Insiue Discussion Paper , Amserdam, The Neherlands. Leeper, E. (1991) Equilibria under acive and passive moneary and fiscal policies, Journal of Moneary Economics, 27, Leeper, E., Walker, T., and S. Yang (2009). Fiscal Foresigh and Informaion Flows, NBER Working Paper 14630, NBER, Cambridge, Ma. Merens, K. and M. Ravn (2008). Undersanding he Aggregae Effecs of Anicipaed and Unanicipaed Tax Policy Shock, forhcoming, Review of Economic Dynamics Monacelli, T. and R., Peroi (2008). Fiscal policy, wealh effecs and markups, NBER Working Paper 14584, NBER, Cambridge, Ma. Mounford, A. and Uhlig, H. (2009) Wha are he effecs of fiscal policy shocks? Journal of Applied Economerics, 24, Nekarda, C., and V. Ramey (2011). Indusry Evidence on he Effecs of Governmen Spending, American Economic Journal: Macroeconomics,3, Pappa, E. (2009). The effecs of fiscal shocks on employmen and he real wage, Inernaional Economic Review, 50, Paredes, J., Pedregal, D., and J. Perez, (2009). A quarerly fiscal daabase for he Euro Area based on inra-annual fiscal informaion, ECB Working Paper 1132, ECB, Frankfur, Germany. Peroi, R.,(2007). In search of he ransmission mechanism of fiscal policy, in D. Acemoroglu, K Rogoff and M. Woodford (eds.), NBER Macro Annual, 22, ,

35 Fiscal policy, pricing fricions and moneary accommodaion 35 MIT Press, Cambridge, Ma. Ramey, V., and M. Shapiro (1998). Cosly capial reallocaion and he effecs of governmen spending, Carnegie Rocheser Conference Series on Public Policy, 48, Ramey, V. (2009). Idenifying governmen spending shocks: I is all in he iming, forhcoming, Quarerly Journal of Economics. Romer, C. and J. Bernsein (2009). The job impac of he American Recovery and Reinvesmen Ac, memorandum, The Whie House. Rossi, B. and S. Zubairy (2009). Wha is he imporance of fiscal and moneary shocks in explaining US macroeconomic flucuaions? forhcoming, Journal of Money Banking and Credi. Roemberg, J. and M. Woodford (1992). Oligopolisic pricing and he effecs of aggregae demand on economic aciviy, Journal of Poliical Economy, 100, Spilimbergo, A., Symansky, S. Blanchard, O. and C. Coarelli (2009). Fiscal policy for he crisis, CEPR Working Paper 7130, CEPR, London, UK. Uhlig, H. (2010). Some fiscal calculus, American Economic Review, 100, Woodford, M. (2011). Simple analyics of he governmen expendiure muliplier, American Economic Journal: Macroeconomics, 3, 1-35.

36 Fiscal policy, pricing fricions and moneary accommodaion 36 Tables and Figures Average US 1.93 (0.65,6.47) EA 1.86 (0.56,7.92) UK 0.89 (0.33,3.21) Large spending consan R US 1.20 (1.15,1.24) EA 0.60 (0.75, 0.86) UK 0.64 (0.61, 0.65) Adding resricions r<0 w>0 Wedge<0 All 2.20 (2.03,2.22) 2.62 (2.55,2.69) 1.90 (1.86,1.94) Recessions 0.80 (0.73, 0.86) 1.25 (1.23, 1.26) 0.35 (0.34, 0.36) 0.33 (0.28,0.35) 0.15 (0.11,0.16) 0.22 (0.18,0.25) Spending Reversals 1.20 (1.18, 1.23) 4.80 (4.70, 4.85) 1.10 (1.08, 1.12) 3.26 (3.13,3.28) 0.54 (0.51,0.58) 0.08 (0.05,0.09) Deb consolidaion 1.32 (1.30, 1.36) 5.70 (5.65, 5.73) 2.70 (2.67, 2.74) 4.84 (4.70,4.98) 3.64 (3.56,3.73) 2.20 (2.15,2.24) Table 1: Conemporaneous per-capia oupu mulipliers. Median esimaes and sandard errors in parenhesis. Basic Condiional Large Spending Recession Spending Reversals Deb Consolidaion G spending >0 >0 >>0 >0 >0 and <0 >0 Defici >0 >0 >0 >0 >0 >0 and <0 afer 2 quarers GDP growh >0 >0 >0 >0 >0 >0 Real wage >0 growh Real rae <0 Labor wedge <0 Nominal rae =0 Tax revenues <0 Inflaion <0 Bond yield =0 Table 2: Conemporaneous idenifying resricions employed, differen scenarios.

37 Fiscal policy, pricing fricions and moneary accommodaion 37 a) Compeiive model W /P N =η(w /P,P /P c, λ) N =η(w /P,P /P c, λ ) W /P =F N (K, N, A ) b) Pricing fricions N W /P N =η(w /P,P /P c, λ) N =η(w /P, P /P c, λ ) W /P =F N (K, N, A )/µ W /P =F N (K, N,A )/µ c) Increasing reurns o scale N N =η(w /P, P /P c, λ) W /P N =η(w /P, P /P c, λ ) W /P =F N (K, N, A ) N Figure 1. Labor marke adjusmens in response o governmen consumpion shocks. W /P is he real produc wage, P c he consumpion deflaor, λ he marginal uiliy of wealh, F n he marginal produc of labor, K capial, N labor, A a echnological shifer, µ he labor efficiency wedge.

38 Fiscal policy, pricing fricions and moneary accommodaion 38 Figure 2: Responses o a defici financed governmen consumpion expendiure shock and per-capia oupu mulipliers. The horizonal axis repors he horizon in quarers.

39 Fiscal policy, pricing fricions and moneary accommodaion 39 Figure 3: Dynamics in response o defici financed large expendiure shocks when he nominal rae is fixed.

40 Fiscal policy, pricing fricions and moneary accommodaion 40 Figure 4: Dynamics in response o defici financed expendiure shocks aking place in recession.

41 Fiscal policy, pricing fricions and moneary accommodaion US EA Real wage Real rae Labor wedge Muliplier x 10-3 x 10-3 Deb o GDP Inflaion Bond yield C/Y UK Figure 5:Dynamics in response o defici financed spending shock which is reversed afer wo periods.

42 Fiscal policy, pricing fricions and moneary accommodaion x US EA Real wage Real rae Labor wedge Muliplier x 10-4 x 10-3 Deb o GDP Inflaion Bond yield C/Y UK Figure 6: Dynamics in response o a defici financed governmen expendiure shock which is consolidaed afer wo period