EUROPEAN ECONOMY. What drives the German current account? And how does it affect other EU member states?

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1 ISSN (online) ISSN 6-86 (prin) EUROPEAN ECONOMY Economic Papers 56 April 24 Wha drives he German curren accoun? And how does i affec oher EU member saes? Rober Kollmann, Marco Rao, Werner Roeger, Jan in Veld, Lukas Vogel Economic and Financial Affairs

2 Economic Papers are wrien by he saff of he Direcorae-General for Economic and Financial Affairs, or by expers working in associaion wih hem. The Papers are inended o increase awareness of he echnical work being done by saff and o seek commens and suggesions for furher analysis. The views expressed are he auhor s alone and do no necessarily correspond o hose of he European Commission. Commens and enquiries should be addressed o: European Commission Direcorae-General for Economic and Financial Affairs Uni Communicaion B-49 Brussels Belgium [email protected] LEGAL NOTICE Neiher he European Commission nor any person acing on is behalf may be held responsible for he use which may be made of he informaion conained in his publicaion, or for any errors which, despie careful preparaion and checking, may appear. This paper exiss in English only and can be downloaded from hp://ec.europa.eu/economy_finance/publicaions/. More informaion on he European Union is available on hp://europa.eu. KC-AI-4-56-EN-N (online) ISBN (online) doi:.2765/6995 (online) KC-AI-4-56-EN-C (prin) ISBN (prin) doi:.2765/776 (prin) European Union, 24 Reproducion is auhorised provided he source is acknowledged.

3 European Commission Direcorae-General for Economic and Financial Affairs Wha drives he German curren accoun? And how does i affec oher EU member saes? (*) Rober Kollmann (ECARES, Universié Libre de Bruxelles and CEPR), Marco Rao (JRC, EU Commission), Werner Roeger, Jan in Veld and Lukas Vogel (DG ECFIN, EU Commission) Absrac We esimae a hree-counry model using daa for Germany, he Res of he Euro Area (REA) and he Res of he World (ROW) o analyze he deerminans of Germany s curren accoun surplus afer he launch of he Euro. The mos imporan facors driving he German surplus were posiive shocks o he German saving rae and o ROW demand for German expors, as well as German labour marke reforms and oher posiive German aggregae supply shocks. The convergence of REA ineres raes o German raes due o he creaion of he Euro only had a modes effec on he German curren accoun and on German real aciviy. The key shocks ha drove he rise in he German curren accoun ended o worsen he REA rade balance, bu had a weak effec on REA real aciviy. Our analysis suggess hese driving facors are likely o be slowly eroded, leading o a very gradual reducion of he German curren accoun surplus. An expansion in German governmen consumpion and invesmen would raise German GDP and reduce he curren accoun surplus, bu he effecs on he surplus are likely o be weak. April 5, 24 JEL Classificaion: F4, F3, F2, E3. Keywords: Curren Accoun, inra-european imbalances, moneary union, Eurozone crisis, esimaed DSGE model (*) The views expressed in his paper are hose of he auhors and should no be aribued o he European Commission. This is he preliminary version of a paper prepared for he 59h Panel Meeing of he journal Economic Policy (CEPR, CES, PSE/ENS), April 24. We are very graeful o Refe Gürkaynak and o hree anonymous referees for deailed and consrucive commens. We also hank Caerina Mendicino and Gábor Pellényi for useful discussions. Helpful commens were also received from Tobias Cwik, Maria Demerzis, Mercedes De Miguel Cabeza, Jakob Friis, Beina Kromen and from workshop paricipans a he EEA, VfS and DYNARE conferences, and a he ECB, Naional Bank of Hungary, Swiss Naional Bank and LUISS (Rome). Research suppor from Jukka Heikkonen, Chrisoph Maier and Bearice Paaracchia is also graefully acknowledged. addresses: [email protected], [email protected], [email protected], [email protected], [email protected] EUROPEAN ECONOMY Economic Papers 56

4 . Inroducion Germany experienced a specacular curren accoun (CA) reversal, afer he launch of he Euro (999). In he 99s, he German curren accoun was in defici, bu close o balance however, in he early 2s, he curren accoun shifed o seadily increasing surpluses, visà-vis boh he res of he Euro Area (REA) and he res of he world (ROW). During he financial crisis, German capial flows o he REA fell abruply, bu he overall German curren accoun surplus bounced back rapidly and reached record levels--85 bill. EUR in 22, i.e. 7 of German GDP--due iner alia o a rise in he surplus vis-à-vis Asia. As a resul, Germany has become one of he major surplus counries in he world. These developmens are currenly a he hear of heaed debaes abou he role of he German surplus and of inra-euro Area exernal imbalances for he crisis and he slow recovery in Europe (see Lane (22), Chen, Milesi-Ferrei and Tressel (22) and Hobza and Zeugner (23) for discussions of inra-ea imbalances). On Ocober 3, 23, he U.S. Treasury sharply criicized Germany s exernal surplus: Germany s anemic pace of domesic demand growh and dependence on expors have hampered rebalancing a a ime when many oher euro-area counries have been under severe pressure o curb demand and compress impors in order o promoe adjusmen. The ne resul has been a deflaionary bias for he euro area, as well as for he world economy (U.S. Treasury (23), p.3). In he Treasury s view: To ease he adjusmen process wihin he euro area, counries wih large and persisen surpluses need o ake acion o boos domesic demand growh and shrink heir surpluses (p.25). The German Governmen swifly rejeced he US criicism. The German Economics Minisry saed ha The Trade surpluses reflec he srong compeiiveness of he German economy and he inernaional demand for qualiy producs from Germany (Wall Sree Journal, Ocober 3, 23); he German Finance Minisry argued ha he German curren accoun surplus was no cause for concern, neiher for Germany, nor for he Eurozone, or he global economy, and ha On he conrary, he innovaive German economy conribues significanly o global growh hrough expors and he impor of componens for finished producs (Financial Times, Ocober 3, 23). The IMF has likewise repeaedly expressed concerns abou he German exernal surplus, and argued ha sronger and more balanced growh in Germany is criical o a lasing recovery in he euro area and global rebalancing (IMF Execuive Board, Augus 6, 23a). By conras o he U.S. Treasury, he IMF s policy advice ceners on srucural reforms in he German economy, such as measures o increase he produciviy of he service secor and labour force paricipaion. The European Commission oo advocaes supply side policies for Germany ha srenghen domesic sources of poenial growh agains he background of unfavourable demographic prospecs (European Commission, Aler Mechanism Repor 24, November 23). In November 23, he persisen German curren accoun surplus riggered an In-Deph Review by he EU Commission, under he Commission s Macroeconomic Imbalances Procedure. The resul of he review were published in March 24 and concluded ha he German surplus consiues an imbalance (see Box on he Macroeconomic Imbalances Procedure below). 2 The goal of his paper is o shed ligh on hese policy issues, using a sae-of-he-ar macroeconomic model. Economic heory suggess ha a counry s curren accoun reflecs domesic and foreign macroeconomic and financial shocks, and he srucural feaures of he domesic and foreign economies. An undersanding of hose shocks and srucural properies Throughou his paper, he erm Euro Area (EA) refers o he 7 counries ha were members of he Euro Area in 23. REA is an aggregae of he EA less Germany. 2 The German exernal surplus has also widely been discussed in he media. Prominen criics of he surplus include Krugman (23) and Wolf (23). 2

5 is hus crucial for posiive and normaive evaluaions of he curren accoun, and for policy advice (Obsfeld and Rogoff (996), Obsfeld (22), Kollmann (998, 2, 24)). This underscores he imporance of analyzing he curren accoun using a srucural model ha capures he relevan shocks, and heir ransmission o he macroeconomy. This paper herefore sudies he German curren accoun using an esimaed Dynamic Sochasic General Equilibrium (DSGE) model wih hree counries: Germany, he REA and he ROW. The model is esimaed using quarerly daa for he period 995q-23q2. The model assumes a rich se of demand and supply shocks in goods, labour and asse markes, and i allows for nominal and real rigidiies, and financial fricions. 3 Several hypoheses abou he causes of Germany's exernal surplus have been debaed in he policy and academic lieraure. Those causes have mosly been discussed separaely, alhough in realiy hese drivers can operae joinly. Our esimaed model allows us o recover he shocks ha drive he German exernal balance and, hence, we can deermine wha shocks maered mos, and when. The model also allows us o assess wha policy measures migh bes be suied for changing he German exernal surplus. We devoe paricular aenion o he following poenial causes of he German exernal surplus: (i) In he run-up o he Euro ( ), REA ineres raes converged o German raes, an indicaion ha he Euro led o greaer financial inegraion in Europe; i has frequenly been argued (e.g., Sinn (2) and Hale and Obsfeld (23)) ha greaer financial inegraion riggered capial flows from Germany o he REA. (ii) A second widely discussed facor was he srong growh in emerging economies during he pas wo decades--german expors may have benefied paricularly from he rising demand for invesmen goods by emerging economies, given German s specializaion in he producion of hose goods; srong growh in emerging economies may have also have added o inra-ea imbalances by increasing compeiion for expors from he EMU periphery (e.g., Chen e al. (22)). (iii) The growh of ousourcing by German firms o low wage counries (noably in Easern Europe), and he German labour marke liberalizaion during he period 22-25, have ofen been viewed as facors ha raised German labour supply, and resrained German wage growh, hereby boosing German compeiiveness (e.g., Dusmann e al. (24)). (iv) Finally, i has been argued ha depressed German domesic demand (as poined ou above), and hus a high saving rae, are key drivers of he German surplus; high saving may parly reflec German households concerns abou rapid populaion ageing, following pension reforms (2-24) ha markedly lowered sae-funded pensions, and creaed ax incenives for privae reiremen saving (Deusche Bundesbank (2), Huefner and Koske (2)). Fiscal consolidaion in Germany afer he financial crisis may also have conribued o weak domesic demand (Lagarde (22), IMF (23b), in ' Veld (23)). Our empirical resuls sugges ha all of hese facors played a role in driving he German exernal surplus, bu ha heir quaniaive imporance and iming differed markedly. Mono-causal explanaions of he German surplus are, hus, insufficien: he surplus reflecs a succession of disinc shocks. According o he esimaed model, greaer financial inegraion (narrowing of he REA-German ineres rae spread) had a posiive effec on aggregae demand in he REA, which boosed REA and German GDP and raised he German curren accoun. However, quaniaively, hese effecs are raher modes, and hey operaed mainly during he lae 99s and early 2s; hus, REA-German ineres rae convergence canno explain he persisence of he rise of he German exernal surplus. We find ha srong ROW growh conribued posiively o German and REA GDP and ne expor he effec of ROW growh was sronger 3 Earlier applicaions of similar models can be found in in Veld, Raciborski, Rao and Roeger (2), Kollmann, Roeger and in Veld (23) and Kollmann, Rao, Roeger and in Veld (23). 3

6 han ha of ineres rae convergence, and i mainly affeced he German exernal balance beween he early 2s and he global recession. German labour marke reforms had a marked effec on German GDP and he German curren accoun, afer 27; hese reforms also had a posiive, bu much weaker, effec on REA GDP (due o sronger German demand for REA expors), and a weak negaive effec on REA ne expors. According o our esimaes, posiive shocks o German privae saving srongly depressed aggregae demand in Germany afer he mid-2s and lowered German GDP, while raising he German curren accoun; hese shocks also simulaed aggregae demand in he REA (due o a fall in ineres raes). All in all, he key shocks ha drove German real aciviy and he German curren accoun only had a minor effec on real aciviy and inflaion in he REA. In oher erms, real aciviy in he REA was largely driven by domesic facors raher han by German economic condiions. The key supply and demand shocks ha kep he German surplus a a high level likewise only had a weak effec on inflaion in he REA. The model also allows us o make predicions abou he fuure pah of he German exernal balance. The rise in he ineres rae spread beween he REA and Germany since he sovereign deb crisis, and pressure oward labour marke reform in he REA sugges a gradual reducion of he German curren accoun surplus. Also he effecs of labour marke reforms enaced in Germany during he early 2s are likely o be gradually eroded by higher German real wage growh, signs of which are already becoming visible (e.g. he new German Federal Governmen eleced in he Fall of 23 plans o inroduce a minimum wage law). The German fiscal sance is also likely o become less resricive, allowing a reversal of he rend decline in public invesmen. And given low ineres raes in Germany, residenial invesmen is also likely o pick up. Wha ligh do hese resuls shed on he policy debae abou he German surplus? Our findings are consisen wih he view ha adverse shocks o domesic demand were key drivers of he surplus, especially afer he mid-2s. Our analysis also suppors he official German view ha srong exernal demand and German compeiiveness gains (wage moderaion and echnological improvemens) were imporan sources of he German exernal surplus. However, srong exernal demand and German compeiiveness gains explain, a mos /3 o /2 of he surplus; srong exernal demand maered mainly before he financial crisis, while wage resrain induced by labour marke reforms conribued o he German surplus afer he mid-2s. The relaive role of hese facors has hus varied grealy across ime. Posiive shocks o he German saving rae have been especially imporan since he mid-2s. The view ha German labour marke reforms represened wage dumping a he expense of foreign economies (e.g., Flassbeck (22)) is no consisen wih our esimaion resuls, due o he very modes effecs of he reforms on real aciviy in he res of he Euro Area. Our analysis suggess ha srucural reforms o raise produciviy and labour supply in he res of he Euro Area would benefi he REA economies, and also lower he German exernal surplus. Boosing German governmen consumpion would only have a modes simulaive effec on German GDP, on he German curren accoun, and on REA GDP. Increases in German governmen invesmen would boos German oupu much more, bu would lead o an even more modes fall in he curren accoun. Measures ha raise German wages would lower German GDP and he German curren accoun. Addiional srucural reforms o boos German aggregae supply would end o furher raise he German exernal surplus, in he shor and medium erm--which conrass wih he ofen-held view ha such measures would lower he German surplus (see above). The presen paper is relaed o a vas empirical and heoreical lieraure ha has sudied sudden sops, i.e. episodes in which large and persisen curren accoun deficis 4

7 suddenly come o an end, due o a drop in foreign capial inflows (e.g. Milesi-Ferrei and Razin (998), Adale and Eichengreen (27), Mendoza (2), Fornaro (23)). By conras, he paper here analyzes a rapid and persisen curren accoun surge ha follows a prolonged period of curren accoun balance. In erms of relaed academic lieraure, i can be noed ha several papers have analyzed he dynamics of he curren accoun using wo-counry DSGE models (e.g., Kollmann (998), Erceg e al. (26)); by conras o he paper here, ha lieraure has ypically used calibraed (no esimaed) models, and i has absraced from housing markes and he key financial fricions considered in he presen model. Jacob and Peersman (23) sudy he deerminans of he US curren accoun defici, using an esimaed wo-counry model; ha model oo absracs from housing and financial fricions. The paper here also differs from hese sudies, by considering a hree-counry se-up. A key advanage of ha seup is ha a German rade surplus does no necessarily lead o a rade defici of he same size in oher EA counries (as would be he case in a sandard wo-counry model). Empirically, he REA rade balance is no a perfec mirror image of he German TB. Also, he REA is a less imporan rading parner for Germany han he ROW; he share of expors o he REA in German expors fell from 46 in 995 o 36 in 22, while he share of he EA in German impors fell from 47 o 37. Secion 2 describes Germany s exernal balance and macroeconomic condiions in Germany, he REA and he ROW, during he period Secion 3 provides a brief overview of our model. Secion 4 presens he model esimaes. Secion 5 concludes. 5

8 Box on Macroeconomic Imbalances Procedure: Drawing lessons from he financial and economic crisis, he European Commission has srenghened macroeconomic surveillance by inroducing he Macroeconomic Imbalances Procedure (MIP) in 2. The aim of he MIP is o idenify poenial risks o macroeconomic sabiliy a an early sage and o ensure ha Member Saes adop appropriae policy responses o preven harmful imbalances and correc hose ha have already buil up. EU Regulaion No 76/2 characerizes a macroeconomic imbalance as "any rend giving rise o macroeconomic developmens which are adversely affecing, or have he poenial adversely o affec, he proper funcioning of he economy of a Member Sae or of he Economic and Moneary Union, or of he Union as a whole." Excessive imbalances are defined as "severe imbalances ha jeopardize or risk jeopardizing he proper funcioning" of EMU. The MIP adops a graduaed approach. The firs sep is a screening for poenial imbalances agains a scoreboard of eleven indicaors, comprising he curren accoun balance, he ne inernaional invesmen posiion, he real effecive exchange rae, nominal uni labour coss, he expor marke share, he unemploymen rae, house price developmens, privae secor credi, privae secor deb, governmen deb, and financial secor liabiliies. The MIP scoreboard esablishes hreshold values for each indicaor. The resul of he screening by he European Commission is published in he annual Aler Mechanism Repor (AMR). The violaion of one or several hreshold values provides an early warning and indicaes he need for furher analysis by he European Commission in he form of an In- Deph Review (IDR). On he basis of he IDR, he Commission deermines wheher imbalances, and excessive imbalances, exis. If he European Commission concludes ha excessive imbalances exis in a Member Sae, i may, in a hird sep, recommend o he European Council ha he Member Sae concerned draw up a correcive acion plan. Afer adopion of he recommendaion by he Council, he European Commission and he European Council monior is implemenaion. Repeaed failure o ake acion can, in a fourh sep, lead o financial sancions: he European Commission can propose o he European Council o levy a fine for no aking acion. The European Council decides by reverse qualified majoriy voe, i.e. sancions are approved unless overurned by a qualified majoriy of Member Saes. The scoreboard-based AMR of November 23 concluded ha IDRs were warraned for 6 Member Saes, including Germany. The IDR for Germany has been moivaed in paricular by he breach of he curren accoun hreshold. The laer issues an aler whenever he hree-year average of he curren accoun balance as a percenage of GDP exceeds 6 or falls below -4. The curren accoun indicaor has upper and lower bounds because boh large surpluses and large deficis can be he resul of inefficiencies and adversely affec he proper funcioning of moneary union. The hreshold values esablish igher limis on he defici side. This derives from he view ha curren accoun deficis pose greaer risk for macroeconomic sabiliy han curren accoun surpluses. In paricular, large and growing deficis are associaed wih risks of sudden sops and financial conagion (European Commission (22b)). The European Commission published is IDR on Germany on March 5, 24. I concluded ha Germany is experiencing macroeconomic imbalances, which require monioring and policy acion. According o he IDR, he large and persisen exernal surplus "sems primarily from a lack of domesic demand, which in urn poses risks o he growh poenial of he German economy." (European Commission (24), p.7). The European Commission argues i would herefore be imporan o idenify and implemen measures ha help srenghen demand and he economy's growh poenial. The repor discusses measures o address he backlog in public invesmen, o furher reduce disincenives o work, o improve he business environmen in order o suppor privae invesmen, and o ensure ha he banking secor has sufficien loss absorpion capaciy o wihsand economic and financial shocks. The IDR did no include an explici quaniaive discussion of spillovers. The Commission will pu forward counry specific recommendaions o deal wih he imbalance by early June 24, for consideraion by he European Council. 6

9 2. Macroeconomic condiions and he German exernal accoun, Germany s curren accoun balance (CA) and rade balance (TB) in he period are ploed in Figure.a. The dynamics of he CA is closely linked o ha of he TB (i.e. o ne expors). Afer close-o-balance posiions in he 99s, he TB and he CA have been in persisen surplus since he early 2s. The German TB and CA surpluses peaked a abou 7 of GDP in 27, receded o abou 5-6 in he global recession of 28-9, and reached 6-7 of GDP in 22; hese persisen surpluses have led o a subsanial posiive inernaional invesmen posiion, ha amouned o 35 of German GDP in 2 (Figure.b). The balance on incomes and ransfers shows a persisen increase (from abou -2 o + of GDP) saring in 23, bu he overwhelming par of he rise in he German curren accoun since he early 2s is linked o he rise in ne expors. 4 Saving, invesmen and he German exernal balance The curren accoun equals he difference beween gross naional saving (S) and gross naional invesmen (I): CA=S-I. Figure.c plos German saving and invesmen, in of GDP (Y). (All raios of variables o GDP discussed in he following paragraphs are raios of nominal variables.) The German invesmen rae (I/Y) rae had a sligh downward rend in he 99s; i fell markedly during he early 2s, and hereafer flucuaed wihou rend around a mean value ha was abou 4 pp (percenage poins) below he mean invesmen rae observed in he 99s. The German saving rae (S/Y) closely racked I/Y unil he early 2s, bu rose markedly and persisenly during he 2s (by close o 4pp beween 2 and 22). This divergence beween saving and invesmen raes accouns for he sharp and persisen rise of he German curren accoun in he early 2s. Figure.d shows ha he persisen rise in he German curren accoun is accouned for by a persisen rise in he privae secor saving-invesmen gap. The German fiscal surplus (governmen S-I) flucuaed cyclically, bu was essenially rendless (as a fracion of GDP), and hus did no conribue o he persisen rise in he German curren accoun. Figure.e shows he conribuions of privae consumpion (C) and governmen consumpion (G), and of invesmen (I) o German ne expors: NX=(Y-C-G)-I. The (C+G)/Y raio has, essenially, been rend-less hroughou he sample period, bu exhibied some marked ransien changes (see Fig..f). 5 Saving, S, equals Y-C-G plus ne incomes and ransfers from he res of he world. The fac ha S/Y rose afer 22, while (Y-C-G)/Y has been rendless is due o he persisen rise in he balance on income and ransfers. Figure.g plos raios of German expors and impors (of goods and services) o GDP. Boh raios have seadily rended upward, doubling during he pas wo decades. The wo raios have mosly moved in andem excep in he period 2-3, when he impors/gdp raio fell, while he expors/gdp raio coninued o grow. Figure.h plos German ne expors o he REA, oal REA ne impors, overall German ne expors, and Euro Area (EA) ne expors (hese variables are repored in of EA GDP). German ne expors are highly posiively correlaed wih REA ne impors. However, he REA rade balance is no a perfec mirror image of he German TB. E.g., he German rade balance surplus remained sizable afer he financial crisis, while REA ne impors fell 4 The rise in he German ne incomes and ransfers balance is solely driven by he rise in ne financial income ha resuled from he rise in he German ne inernaional invesmen posiion. Ne inernaional ransfers are very sable across ime, and represen abou -.4 of German GDP hroughou he sample period. The ne income balance was slighly negaive during he second half of he 99s. Thereafer, ne income rose seadily, due o he rise in he German ne inernaional invesmen posiions, and reached 2.4 of German GDP in 22. Ne financial income accouns for he lion share of ne income (ne employee income is negligible). 5 Saving, S, equals Y-C-G plus ne ransfers and incomes from he res of he world. The fac ha S/Y rose afer 22, while (Y-C-G)/Y has been rendless is due o he persisen rise in he balance on income and ransfers. 7

10 sharply. The rise in German ne expors o he REA only accouns for abou one half of he deerioraion of he overall REA rade balance beween he 99s and 28. The EA as a whole ran a rade balance surplus hroughou he sample period. During he sample period, he share of he (fas-growing) ROW in oal German foreign rade has risen seadily. The share of expors o he REA in German expors fell from 46 in 995 o 36 in 22, while he share of he EA in German impors fell from 47 o 37. Real aciviy in Germany and in German expor markes Figures 2.a plos volume series of GDP, privae consumpion, governmen purchases and invesmen for Germany (compared o he base year 995). German privae consumpion growh in real erms has been lower han real GDP growh since he mid-2. (The sabiliy of he raio of nominal consumpion o nominal GDP documened above reflecs a gradual rise in he raio of he German CPI o he German GDP deflaor.) More srikingly, however, real invesmen demand has almos had a fla rend beween 995 and 22, experiencing mainly emporary ups and downs. Figure 2.b plos year-on-year (YoY) growh raes of real GDP in Germany, he REA and he ROW. (ROW oupu is aggregae real GDP in 4 indusrialized and emerging economies, including EU members who are no EA members; see Appendix.) Oupu growh flucuaions have been highly synchronized across hese counries/regions. However, German real GDP grew noiceably less han REA and ROW GDP during The gap in growh raes was especially sizable in During ha period Germany was someimes referred o as he laggard of Europe (Sinn, 23). Since 26, German GDP has grown faser han REA GDP, excep during he Grea Recession of 29. ROW growh has markedly exceeded REA growh since he early 2s. REA-German ineres rae convergence The creaion of he Euro eliminaed exchange rae risk, and reduced financial ransacion coss across member counries. The dae of he launch of he Euro (..999) was announced by he European Council in December 995. Unil 995, he shor erm nominal ineres on governmen deb was markedly higher in he REA han in Germany; see Figure 3.a (mean REA-German ineres rae spread: 2.3 p.a. in ). The German nominal ineres rae had a fla rend beween 995 and 999, while he REA nominal rae fell rapidly, and hus converged o he German rae. The REA-German nominal ineres rae spread was (essenially) zero when he Euro was launched in 999. Beween 999 and he financial crisis, he ineres rae spread remained very small; a posiive spread emerged again afer he erupion of he sovereign deb crises in some REA counries (2). Exchange raes and inflaion Due o srong domesic demand (fuelled i.a. by expansionary fiscal policy) he Deusche Mark (DM) appreciaed agains REA currencies beween German Reunificaion (99) and 995. The DM hen depreciaed agains he REA unil he launch of he Euro, bu ha depreciaion only parly undid he srong pos-reunificaion appreciaion (see Figure 3.c). I has been argued ha Germany enered EMU a an overvalued exchange rae--and ha hence low wage and price growh was needed o re-esablish German compeiiveness (inernal devaluaion) afer he launch of he Euro (e.g., Louanges (25) and Caron and Hervé (22)). The real exchange rae of Germany ploed in Figure 3.d is consisen wih ha view. The Deusche Mark appreciaed in real erms agains boh he REA and he ROW, afer Reunificaion. Real appreciaion peaked in 995; he German real exchange rae agains he REA was sill above pre-unificaion levels when German-REA bilaeral exchange raes were frozen a he beginning of 999. Afer he launch of he Euro, German real depreciaion vis-à-vis he REA has coninued via lower German inflaion (see Figure 3.b): he average 8

11 annual growh rae of he GDP deflaor afer 999 was.75 in Germany, and 2.49 in he REA. The nominal (effecive) exchange raes of Germany agains he ROW depreciaed much more srongly han he German-REA exchange rae, beween 995 and 2; he German-ROW exchange rae hen appreciaed, by more han 7, unil 28. Since he financial crisis, he exernal value of he Euro has flucuaed widely, around a sligh downward rend (Fig. 3.d.). Due o nominal ineres rae convergence, he lower German inflaion implied ha he German real ineres rae was higher han he REA real ineres during he firs years of he Euro. The financial crisis led o a rise in German inflaion, and o a sharp reducion in REA inflaion. Labour marke reforms As a response o sagnan real aciviy in he early 2s, he German governmen implemened a far-reaching labour marke deregulaion in 23-5 ( Harz reforms) ha included a reducion in unemploymen benefis and measures such as a re-organizaion of labour placemen and of job raining schemes o improve job maching. Fig. 4.d plos he German average unemploymen benefi raio (raio of unemploymen benefi o wage rae). The benefi raio fell permanenly in 24-5, from 62 o 53. German labour marke reforms arguably weakened he bargaining power of German rade unions. The fracion of wage earners who are union members fell seadily from 29 in 995 o 8 in 2 (OECD (23)). I has been argued ha he growh of ousourcing by German firms o low wage counries, noably in Easern Europe, also reduced German rade union power (Dusmann e al. (24)). These developmens may have conribued o he very low growh of wages and of uni labour coss in Germany and hus o low German inflaion (see below). These facors raised he compeiiveness of German exporers, relaive o he res of he EA. Wages and uni labour cos Nominal wage growh has been markedly lower in Germany han in he aggregae EA during mos of he Euro-era (see Fig. 4.a). Beween 22 and 2, real wage growh has also been lower in Germany han in he EA. In fac, German real wage growh was negaive during par of his period (Figure 4.b). As a resul of hese developmens, he German labour share (share of wage income in GDP) fell seadily, from 57 in he early 99s o 49 in 28. Nominal uni labour cos (ULC, raio of nominal compensaion per employee o real GDP per person employed) was essenially fla beween 995 and 27, or fell slighly, and only sared o rise (by abou +) afer he financial crisis (Fig. 4.c). By conras, nominal ULC rose seadily in he REA, beween 995 and 28, bu has been sable consan since hen. Demographics and pension reforms One prominen candidae for explaining he German exernal surplus is populaion ageing. Empirical research by he IMF (23b) provides evidence for a srong posiive impac of projeced ageing speed on he curren accoun balance. Based on a sample of 49 counries (986-2), he IMF finds ha a percenage-poin increase in he old-age dependency raio (defined as he number of people aged 65 and above, relaive o he working age populaion) relaive o he counry average increases he curren accoun balance by.2 percenage poins. In Germany, he dependency raio increased by percenage poins beween he mid-99s and 22 (Figure 5.a). Projecions (German Council of Economic Advisors (2)) poin o an increase by around 2 percenage poins wihin he nex 2 years, due o he reiremen of he pos-war baby boom cohors. Imporanly, he speed of populaion ageing is higher in Germany han in mos oher major economies. Higher fuure old-age dependency raios imply lower fuure per-capia pension enilemens or higher fuure financing coss in a PAYG sysem, which boh reduce fuure disposable income and provide an incenive o increase privae savings. 9

12 In Germany, he pension replacemen rae (raio of he average pension o he average wage income per employee) has fallen by 3 pp beween he lae 99 s and 22 (Figure 5.b). Public pension reforms enaced in Germany beween 2 and 24 sipulae a rise in mandaory public pension conribuions and in he reiremen age, as well as reducion of pension benefis (hese changes are being phased-in gradually); in addiion, he reforms have provided new ax incenives for privae pension saving (Deusche Bundesbank, 2; Huefner and Koske, 2). 3. Modeling he German curren accoun: key relaionships This Secion discusses he main relaionships in our model ha allow us assess he role of he key poenial drivers of he German curren accoun discussed in he previous Secion. We solve he model by linearizing i around a deerminisic seady sae; he linearized model is esimaed wih Bayesian mehods, using quarerly German, REA and ROW daa for he period 995q-23q2. We begin our esimaion sample in 995q in order o include he pre-euro convergence of ineres raes in our sample; by 995q he creaion of he Euro was highly likely; he dae of he launch of he Euro was officially announced in December 995, as menioned above. (As a robusness check, we also esimaed he model for ; he key resuls remain unchanged.) The Appendix provides a complee descripion of he model and of he economeric mehodology. Our model builds on he EU Commission s Ques III model (Rao, Roeger and in Veld (29)), an empirical New Keynesian Dynamic General Equilibrium wih rigorous microeconomic foundaions. Recenly, much research effor has been devoed o he esimaion of macroeconomic models of his ype; see, e.g., Chrisiano, Eichenbaum and Evans (25), Kollmann, Roeger and in Veld (22), Kollmann, Rao, Roeger and in Veld (23), Kollmann (23). This class of models is widely used for research and for macro policy analysis. The lieraure shows ha his class of models capures well key feaures of macroeconomic flucuaions in a range of counries for example, hese models ypically generae second momens (sandard deviaions and correlaions) of key macro variables ha are close o empirical momens. This is also he case for he model here (see Appendix). 6 Our model assumes hree counries: Germany, he REA and he ROW. The German block of he model is raher deailed, while he REA and ROW blocks are more sylized. The German block assumes wo represenaive households: One household has a low rae of ime preference and holds financial asses ( saver household ). The oher household has a higher rae of ime preference, and borrows from he saver household using her housing sock as collaeral. We assume ha he loan-o-value raio (raio of borrowing o he value of he collaeral) flucuaes exogenously, and ha he collaeral consrain binds a all imes. (This srucure, wih paien and impaien households and exogenous loan-o-value shocks, builds on Iacoviello and Neri (2).) Boh households provide labour services o goods producing firms, and hey accumulae housing capial worker welfare depends on heir consumpion, hours worked and sock of housing capial. The paien household owns he German goods producing secor and he consrucion secor; in equilibrium, he paien household also holds financial asses (governmen deb, foreign bonds). 6 There are few empirical macro models for Germany. Pylarczyk (25) esimaed a wo-counry DSGE model wih daa for German and he Euro Area. His model is more sylized han our model; no daa on he exernal balance are used--no implicaions for he exernal balance are discussed. However, Pylarczyk s parameer esimaes share some of he broad feaures of our esimaes, e.g. his resuls also suppor gradual demand adjusmen (consumpion habi persisence) and nominal sickiness.

13 German firms maximize he presen value of he dividend sream paid o he paien (capialis) household. We assume ha German firms ren physical capial from saver households a a renal rae ha equals he risk-free ineres rae plus an exogenous sochasic posiive wedge; ha wedge hence creaes a gap beween he marginal produc of capial and he risk-free ineres rae. This is a shor-cu for analyzing financial fricions facing firms (e.g., Buera and Moll (22)). German firms expor o he REA and he ROW. The producion echnology allows for variable capaciy uilizaion and capial and labour adjusmen coss; household preferences exhibi habi formaion in consumpion (i.e. sluggish consumpion adjusmen o income shocks). These model feaures help o beer capure he dynamics of he German curren accoun and of oher German macro variables. The German block also assumes a governmen ha finances purchases and ransfers using disoring axes and by issuing deb. The German block assumes exogenous shocks o preferences, echnologies and policy variables ha aler demand and supply condiions in markes for goods, labour, producion capial, housing, and financial asses. The models of he REA and ROW economies are simplified srucures wih fewer shocks; specifically, he REA and ROW blocks each consis of a New Keynesian Phillips curve, a budge consrains for a represenaive household, demand funcions for domesic and impored goods (derived from CES consumpion good aggregaors), and a producion echnology ha use labour as he sole facor inpu. The REA and ROW blocks absrac from producive capial and housing. In he REA and he ROW here are shocks o labour produciviy, price mark ups, and he subjecive discoun rae, as well as moneary policy shocks, and shocks o he relaive preference for domesic vs. impored consumpion goods. 7 All exogenous variables follow independen univariae auoregressive processes. In oal, 46 exogenous shocks are assumed. Oher recen esimaed DSGE models likewise assume many shocks (e.g., Kollmann (23)), as i appears ha many shocks are needed o capure he key dynamic properies of macroeconomic and financial daa. The large number of shocks used here is also dicaed by he large number of observables used in esimaion (as he number of shocks has o be a leas as large as he number of observables o avoid sochasic singulariy of he model). In order o evaluae alernaive hypoheses abou he causes of he German exernal surplus, daa on a relaively large number of variables have o be used we use daa on 44 macroeconomic and financial variables for Germany, he REA and he ROW (see Appendix). We now provide a (slighly) more deailed overview of key model componens: Moneary policy Moneary policy in he Euro Area is described by an ineres rae (Taylor) rule. We assume DE ha he pre-999 policy rae is he German shor-erm governmen bond rae, denoed by i +. During EMU (999-), he policy rae is aken o be a weighed average of i DE + and of he REA REA shor-erm governmen bond rae, i + : EA DE REA i+ = si+ + ( s) i+, () where s=.275 is he average share of German GDP in EA GDP during he sample period. The policy rae is se as a funcion of he lagged policy rae, of he year-on-year Euro Area inflaion rae (GDP deflaors), of he year-on-year growh rae of Euro Area real GDP, and of 7 We se each counry s ne foreign asses (NFA) a zero in seady sae (and hus he seady sae curren accoun and ne expors oo are zero). In he long run, NFA is expeced o converge o is seady sae however convergence is slow. Shor- and medium erm model dynamics hus does no depend on he assumed NFA seady sae; our esimaion resuls are robus o assuming non-zero seady sae NFA.

14 a random disurbance. 8 (The average sovereign bond rae defined in () racks very closely he acual ECB policy rae, during he period ; correlaion:.97.) Ineres rae spreads We assume ha he uncovered ineres rae pariy condiions ha link German, REA and ROW ineres raes are disurbed by exogenous shocks (e.g. McCallum (994), Kollmann (22)): EA ROW EA, ROW EA, ROW i = i + E ln e + ρ, (2) i = i + E ln e + ρ, (3) REA DE REA, DE REA, DE + + +, where e jk is he nominal (effecive) exchange beween counries j and k, defined as he price of one uni of counry-k currency, in unis of he counry-j currency. The rae of depreciaion of he EA currency agains he ROW currency is a weighed average of he raes of appreciaion of he German and REA currencies (vis-à-vis he ROW): EA, ROW DE, ROW REA, ROW lne+ = s ln e+ + ( s) lne+. (4) EA, ROW, ρ and ρ REA DE are exogenous saionary disurbances ha drive wedges beween he (average) EA ineres rae and he ROW ineres rae, and beween he REA and German ineres raes; hose wedges can reflec limis o arbirage (due o ransacion coss or shorsales consrains), biases in (subjecive) expecaions abou fuure exchange raes, or risk, premia. In wha follows, we will refer o EA ROW, ρ and ρ REA DE as risk premia., Since he inroducion of he Euro, REA DE DE, ROW e has been consan; hus lne + = REA, ROW lne + holds afer he launch of he Euro. During he run-up o he Euro ( ), he bilaeral REA/German exchange rae only showed mued flucuaions (see Figure 3.c). We assume ha agens believed he REA/German exchange rae o follow a random walk REA, DE during he ransiion period, i.e. ha E ln e + =. This assumpion allows o, consruc a ime series for he German-REA risk premium: ρ REA DE REA DE. = i+ i 9 + We feed he REA-German risk premium ino our model o assess he effec of he convergence of REA and German ineres raes on macroeconomic variables and he German exernal balance. Our ROW empirical measure of he ROW ineres rae i + is he shor-erm US governmen bond rae; EA, ROW he USD exchange rae is aken as our empirical measure of e +. Invesmen in producive capial and firm financing condiions In he model, German good producing firms ren he physical capial sock from he paien (capialis) households. Goods producing firms equae he marginal produc of capial o he renal rae. The renal rae equals he risk-free ineres rae plus an exogenous random posiive wedge. The producion funcion is subjeced o exogenous oal facor produciviy (TFP) 8 We assume ha in (before he launch of he Euro), he Bundesbank se moneary policy for all counries in he (fuure) Euro Area. The parameers of he policy rule are assumed o be he same in and in (any discrepancies beween Bundesbank and ECB policy rules are hus capured by he residual of he policy rule). Assuming insead ha pre-999 he Bundesbank responds only o German oupu and inflaion would be echnically challenging, as his would inroduce a break in he policy rule. Sandard soluion and esimaion algorihms for linear(ized) models (as used here) require equaions wih ime-invarian coefficiens. 9 During he run-up o he Euro, he (fuure) member counries already made a commimen o keep sable bilaeral exchange raes. The Maasrich Treay sipulaed ha a (fuure) member counry of he Euro Area had o absain from devaluing is currency for a leas wo years (before joining he EA), agains any oher member counry. Hence, i seems reasonable o assume ha expeced exchange rae depreciaion was zero (or close o zero) in During his period he REA nominal exchange rae appreciaed slighly agains he DM (by 3.85). The compounded REA-Germany ineres rae differenial was much greaer:

15 shocks; he accumulaion of producion capial is affeced by shocks o invesmen efficiency (e.g., Fisher (26) and Jusiniano e al. (28)). Fiscal policy The governmen purchases domesically produced and impored inermediae goods ha are used for governmen consumpion, and for invesmen in public capial; he governmen also pays unemploymen benefis and pensions o households. Governmen spending is financed using axes on consumpion, labour income and capial income, and by issuing public deb. All governmen spending iems and he ax raes are se according o feedback rules ha link hose fiscal variables o he sock of deb (in a manner ha ensures governmen solvency), and o real oupu. The fiscal policy rules are also affeced by exogenous auocorrelaed disurbances. Exernal demand condiions and foreign rade shocks Consumpion and invesmen are composie goods ha are produced by combining locally produced and impored inermediae goods ha are imperfec subsiues. The volume of German foreign rade, hence, depends on he relaive price beween German and foreign (REA and ROW) goods, and on domesic and foreign absorpion. We use daa on foreign real aciviy and on he foreign price level, in he model esimaion. We refer o shocks o foreign real aciviy as exernal demand shocks, as hese shocks affec he demand for German expors. The model also assumes preference shocks ha shif he desired combinaion beween domesic and impored inermediaes, and shocks o he marke power (mark up) of exporers. Labour marke reforms and wage resrain In he model, he governmen pays unemploymen benefis o unemployed workers (hose benefis are equivalen o a subsidy for leisure). We capure he effec of he German labour marke reforms by reaing he unemploymen benefi raio as an auocorrelaed exogenous variable. We feed he hisorical benefi raio (Figure 4.d) ino he model. We assume ha German wages are se by a labour union ha acs like a monopolis in he labour marke. Union power, as manifesed in he wage markup (i.e. markup of he real wage rae over workers marginal rae of subsiuion beween consumpion and leisure) follows an auocorrelaed process. Privae saving and financial condiions shocks To capure he rise in German privae saving, he model allows for exogenous shocks o households rae of ime preference, referred o as privae saving shocks. We also assume ha he loan-o-value raio faced by impaien households (borrowers) is ime-varying. Pensions To keep he model simple, we assume infiniely-lived German households (i.e. we do no consider overlapping generaions). Each household has a fixed ime endowmen ha is normalized a uniy. Tha ime endowmen is used for marke labour, leisure and reiremen. We assume ha ime spen in reiremen (R) is exogenous. In he empirical esimaion, we ake he fracion of he populaion in reiremen as a proxy for R. The pension paid o a given household is modeled as a governmen ransfer; he pension is proporional o R and he marke wage rae, w: pension= rr *R*w, where he pension replacemen rae rr is an exogenous random variable. We use he empirical replacemen rae (Figure 5.b) as a measure of rr, in he model esimaion. 3

16 4. Resuls The Appendix repors poserior esimaes of all model parameers. The esimaion indicaes ha he German seady sae income share of financially unconsrained households ( savers ) is high (.54). German households exhibi relaively srong habi persisence (habi parameer:.7), and so do REA and ROW households (habi parameers:.67 and.9). German households have an ineremporal subsiuion elasiciy below uniy (.58). The German (Frisch) labour supply elasiciy is.82. German nominal wage and price sickiness is moderae: he average price-change inerval is 3 quarers, while he average wage-change inerval is 2 quarers. (Despie he modes degree of nominal wage sickiness, he impulse responses show ha he real wage rae exhibis subsanial sluggishness.) The subsiuion elasiciy beween domesic and impored producs is high (2.) in Germany, close o uniy (.3) in he REA and below uniy (.74) in he ROW. To explain he key mechanisms operaing in he model, we now presen impulse responses o seleced shocks. We hen describe shock decomposiions of hisorical ime series, implied by he esimaed model. All model properies are evaluaed a poserior esimaes (modes) of he model parameers. Oher deailed esimaion resuls are repored in he Appendix. 4.. Impulse response funcions We now discuss dynamic responses o shocks ha maer mos for he German exernal balance. We begin by discussing shocks o German aggregae supply (shocks o German TFP and invesmen efficiency, and o German unemploymen benefis), and hen discuss German saving shocks, shocks o German governmen consumpion and invesmen, a shock o he REA-Germany risk premium, and a ROW demand shock. Posiive German aggregae supply shocks: TFP and invesmen efficiency increase, unemploymen benefi raio Figure 6.a shows dynamic responses o a permanen rise in German TFP. In he shor-run, price sickiness and capial and labour adjusmen coss preven a rapid expansion of German oupu. Hence, he shock riggers a gradual increase in German GDP (he maximum response of GDP is reached 5 years afer he shock), and of he German real wage rae. Due o habi formaion in consumpion (and because of he presence of collaeral-consrained households), aggregae German consumpion oo rises very gradually in fac more slowly han GDP; hence, he German saving rae (nominal saving/nominal GDP) rises. On impac, he German labour inpu falls slighly, due o he sluggish adjusmen in aggregae demand--employmen only rise wih a four quarer delay. Producive invesmen in Germany oo falls slighly, on impac, before rising. Imporanly, invesmen rises less han GDP (due o srong invesmen adjusmen coss) and, hence, he invesmen rae (nominal invesmen/nominal GDP) falls. The shock also leads o a gradual fall in he German price level, and o a depreciaion of he German real exchange rae vis-à-vis he REA. The policy ineres rae falls, bu only very slighly, as EA moneary policy arges EA-wide aggregae GDP and inflaion. Due o he gradual fall in he German price level, he German (expeced) real ineres rae rises, which also conribues o he iniial fall in German producive invesmen. The sluggish rise in German absorpion and he improvemen in German price compeiiveness (fall in he relaive German/REA oupu price) implies ha German ne expors and he German curren accoun rise persisenly. The rise in German ne expors is accompanied by a persisen fall in REA ne expors. Domesic demand in REA increases suppored by he decline in he policy rae. 4

17 The ne effec on REA GDP is small, iniially posiive bu urning negaive in laer years and noe ha he reducion in REA GDP is markedly smaller han he rise in German GDP. The prediced fall in foreign GDP in response o a posiive shock o home produciviy is a common feaure of open economy DSGE models (e.g., Backus, Kehoe and Kydland (992), Kollmann (23)). By conras, he sign of he ne expors response hinges on he speed of adjusmen of consumpion and invesmen, and is hus parameer-dependen. Our model esimaes sugges very sluggish German consumpion adjusmen (srong habi effecs) o a German TFP increase. In he absence of habi formaion, absorpion would iniially rise more srongly han curren GDP, due o consumpion smoohing by local households who expec heir fuure income o rise more han curren income, and hus ne expors and he curren accoun would hen fall (e.g. Obsfeld and Rogoff (996)). Figure 6.b shows dynamic responses o a posiive shock o German privae secor invesmen efficiency (producion capial). Qualiaively, he response of mos variables are similar o he responses o a posiive TFP shock: he invesmen efficiency shock raises German real GDP, consumpion and invesmen. However, German oupu rises less srongly, while consumpion rises by less, invesmen rises by more han in response o a posiive TFP shock. The posiive invesmen efficiency shock riggers a fall in he relaive price of invesmen goods, relaive o he GDP deflaor. This negaive price response implies ha a posiive invesmen efficiency shock riggers a fall in he (nominal) invesmen rae. The change in he saving rae exceeds he fall in he invesmen rae, and hus he German curren accoun rises. Figure 6.c repors dynamic responses o a German labour marke reform capured here by an exogenous permanen reducion in he German unemploymen benefi raio (unemploymen benefi divided by wage income per employee). The benefis cu raises German labour supply, which lowers he real wage rae. I hus leads o a long-lasing expansion of German employmen, and of German GDP, and o an improvemen in German compeiiveness. Alhough he compeiiveness gain is persisen, i is gradually eroded as real wages adjus in he longer run. The lower unemploymen ransfer paymen reduces he consumpion of collaeral-consrained German households. Aggregae consumpion iniially declines bu rises (above he unshocked pah) afer six years (due o he increase in GDP which raises he consumpion of saver households). However, consumpion adjuss sluggishly o he rise in GDP, and he German saving rae rises persisenly. German invesmen falls, on impac, due o a rise in he German real ineres rae, bu invesmen increases in he mediumerm, as he (permanen) rise in he German labour supply riggers a permanen rise in he German capial sock. REA oupu rises slighly in he shor erm, and hen falls slighly below is unshocked pah. German ne expors increase, while REA ne expors fall. The effecs of his shock on German GDP and on German ne expors are hus similar o he responses riggered by a posiive TFP shock--bu noe ha he German benefis reducion raises REA oupu in he shor run. Posiive German aggregae supply shocks are, hence, a candidae for explaining he acceleraion of German GDP growh afer 25. These shocks are also consisen wih oher salien facs abou he German economy afer 25: a high rade balance (and curren accoun) surplus, low inflaion (relaive o he REA) and a high saving rae. Posiive German privae saving shock, shocks o pension replacemen rae and o old-age dependency raio The oher shocks discussed below (excep he saving shock) oo move he German GDP and rade balance (and curren accoun) in he same direcion. In he model, he German curren accoun is hus procyclical, consisen wih daa. 5

18 Figure 6.d shows dynamic responses o a posiive German privae saving shock, namely a persisen fall in he German subjecive rae of ime preference. The shock riggers a longlasing reducion in German aggregae consumpion, and i hence raises he German saving rae. The resuling increase in he marginal uiliy of consumpion raises households (desired) labour supply, which induces a gradual fall in he German (real) wage rae, and in he German price level. Because of sluggish price and wage adjusmen, he shor- o medium-erm response of German GDP and employmen is, however, dominaed by he fall in consumpion i.e. GDP and employmen fall iniially, before rising above heir unshocked pah (due o he increased labour supply). The rise in privae saving lowers he nominal ineres rae, however he fall in German inflaion leads o an iniial rise in he German real ineres rae, and German invesmen falls on impac (bu hen increases). REA aggregae demand rises (due o fall in EA-wide ineres rae), and REA ne expors fall (also because of a fall in German demand for REA goods). Iniially, REA GDP is slighly posiive, bu hen falls slighly below is unshocked pah. A cu in he pension replacemen rae oo raises German GDP, he German saving rae (due o fall in consumpion) and ne expors. A posiive shock o he old-age dependency raio (i.e. o he number of German reirees) lowers German employmen (due o labor supply reducion) and oupu; consumpion and invesmen fall oo, bu more gradually han oupu, and hus German nex expors (and he curren accoun) fall. (The hisorical decomposiions of he curren accoun discussed below show ha shocks o he pension replacemen rae and o he number of reirees had a smaller role for he German saving-invesmen gap han rae-of-ime preference shocks.) German fiscal shocks Figure 6.e repors responses o a posiive shock o German governmen consumpion. The shock raises German GDP, bu crowds ou German consumpion and invesmen, and i reduces German ne expors, and raises REA oupu. A Euro rise in governmen purchases raises German oupu by.56 Euro, lowers German ne expors by.35 Euro, and raises REA GDP by.2 Euro. Thus, German expansionary fiscal policy lowers German ne expors, bu only has a very small effec on REA GDP. In order o reduce German ne expors by of GDP, a fiscal impulse worh 2.85 of GDP would be required, which amouns o a 5 increase in governmen purchases. In oher erms, even very sizable fiscal policy shocks only have a modes effec on ne expors (and on he curren accoun). (Modes rade balance responses o fiscal shocks in he same range are also repored by oher empirical sudies; see, e.g., Beesma and Giuliodori (2)). Figure 6.f shows dynamic responses o a posiive shock o German public invesmen. The shock has a sizable effec on German GDP ha grows over ime. Privae consumpion increases, and German ne expors fall slighly during he firs 4 years afer he shock. Iniially, privae invesmen falls, bu in he medium erms privae invesmen rises, as he rise in governmen capial raises he produciviy of privae producion capial. REA GDP falls, in he very shor erm, bu rises subsequenly. Fall in spread beween REA bonds and German bonds Figure 6.g shows dynamic responses o a persisen fall in he REA-German bond spread, (risk premium) ρ REA DE REA DE = i+ i+. The shock riggers a persisen fall in he (nominal and real) REA ineres rae, and a rise in he EA policy rae. REA absorpion and GDP and he The responses of real aciviy are mued by a rise in he policy rae. When moneary policy is consrained by he zero lower bound (ZLB), he ineres rae fails o rise, and REA GDP increases already on impac. 6

19 (relaive) REA price level rise, while REA ne expors fall. The rise in he policy rae riggers a sharp and persisen fall in German invesmen, and a fall in German consumpion. The German invesmen rae falls, while he saving rae rises. German GDP rises due o srong REA demand, and German ne expors increase. The effecs on German and REA ne expors are very persisen. These predicions are consisen wih a number of developmens in he run-up o he Euro when he REA-German ineres rae spread fell rapidly: namely rapid REA growh and a worsening of he REA rade balance. However, empirically German ne expors were basically fla before he launch of he Euro, which suggess ha oher facors mus have off-se he effec of he spread shock on German ne expors. Posiive shock o ROW (Res of World) aggregae demand Finally, Figure 6.h shows responses o a rise in ROW aggregae demand riggered by a persisen rise in he ROW subjecive discoun rae. The shock raises ROW absorpion, which increases demand for German and REA expors, and hus German and REA GDP rise. This riggers a rise in he EA policy rae, which reduces German invesmen by increasing financing coss. Again, he German invesmen rae falls, while he saving rae rises. ROW ne expors fall, while German and REA ne expors rise. Hence, he ROW real aciviy shock is consisen wih high German ne expors and low German invesmen Hisorical decomposiions To quanify he role of differen shocks as drivers of endogenous variables, we plo he esimaed conribuion of he differen shocks o hisorical ime series. Figures 7.a-7.e show hisorical decomposiions of he following German macroeconomic variables: he curren accoun (divided by nominal GDP); he saving rae; he invesmen rae; year-on-year real GDP growh; and year-on-year inflaion (GDP deflaor). Figures 8.a-8.b show decomposiions of he REA rade balance (divided by REA nominal GDP) and of REA real GDP growh. The lines wih black lozenges show he hisorical daa. In each Figure, he horizonal line represens he seady sae value (of he variable ploed in he respecive Figure). (In he model, he seady sae year-on-year growh rae of German and REA GDP is.8; seady sae annual inflaion is 2.) For each period (quarer), he verical bars show conribuions of differen (groups of) shocks o he hisorical daa. For he sake of legibiliy, relaed disurbances are grouped ogeher (see below). Verical bars above he horizonal (seady sae) line represen posiive shock conribuions o he variable considered in he Figure, while bars below he horizonal line represen negaive conribuions. Sums of all shock conribuions equal he hisorical daa. We plo he conribuions of he following (groups of) exogenous shocks originaing in Germany: () TFP and invesmen efficiency (see bars labeled echnology ); (2) Wage mark up ( Labour wedge ); (3) Unemploymen benefi raio ( Unemploymen benefi ); (4) Old-age dependency raio ( Reirees ); (5) Pension replacemen rae; (6) Subjecive rae of ime preference ( Privae saving ); (6) Fiscal policy; (7) Firm finance wedge; (8) Household loan-o-value raio and risk premium on housing capial ( housing financing condiions ). In addiion, we show he conribuion of disurbances o: () REA-German ineres rae spread ( REA risk premium ); (2) shocks originaing in he REA and ROW, and shocks o he relaive preference for German vs. impored goods ( Exernal demand and rade ). The remaining shocks are markedly less imporan drivers of German variables, and are hence combined ino a caegory labeled oher shocks. 2 2 Also included in oher shocks are he base rajecories, i.e. he dynamic effecs of iniial condiions (i.e. of predeermined saes in he firs period of he sample). 7

20 Figures 8.a and 8.b (decomposiions of REA ne expors and GDP growh) show he conribuions of he (groups of) shocks originaing in Germany, as well as he conribuions of REA aggregae demand shocks and of REA aggregae supply shocks, and of REA exernal demand and rade shocks (ROW aggregae demand and supply shocks, and shocks o he relaive preference for REA goods vs. goods impored by he REA). The hisorical decomposiion shows ha he following shocks had a noiceable posiive effec on he German curren accoun, a differen imes: (i) posiive German echnology shocks, beween he lae 99s and he global financial crisis; (ii) he fall in he REA-German risk premium, beween 995 and 999; (iii) posiive exernal demand shocks, due o srong ROW and REA growh, especially in 24-8; (iv) he 23-5 German labour marke reforms (capured in he model by he reduced generosiy of unemploymen benefis); (v) sizable posiive shocks o he saving rae, from 24 o he end of he sample; (vi) a rise of German firms invesmen wedge, afer he collapse of he do-com bubble, and in he afermah of he global financial crisis. German echnology shocks had a persisen posiive effec on he German invesmen rae, according o he esimaed model, and boosed he German curren accoun by up o.5 of GDP during he early 2s, i.e. during he phase during which he curren accoun rose sharply. The posiive conribuion of echnology shocks o he German curren accoun beween he early 2s and he financial crisis mainly reflecs he fac ha hese shocks (in paricular invesmen efficiency shocks) lowered he German invesmen rae (see above discussion of impulse responses). During he 29 financial crisis, TFP and invesmen efficiency fell noiceably in Germany his explains why he influence of echnology shocks on he German curren accoun has been much weaker since he crisis. Aggregae supply shocks were key drivers of German GDP: he booms in 2-2 and are boh accouned for by sizable posiive supply shocks. Aggregae supply shocks also had a noiceable effec on German inflaion: posiive echnology shocks in he firs half of he sample period lowered German inflaion; negaive echnology shocks during he Grea Recession prevened a drop in inflaion. The convergence of REA ineres raes o German raes had a persisen small bu noiceable posiive effec on German curren accoun beween he lae 99s and he mid- 2s (see bars labeled REA Risk premium shocks in Figure 7.a). Ineres rae convergence increased REA demand and hus REA impors from Germany. Because of moneary policy ighening in response o ineres rae convergence (see Figure 6.g), German aggregae demand fell, in response o convergence, which led o declining domesic demand and a rise in German saving. As discussed above, ineres rae convergence occurred rapidly afer he creaion of he Euro had irrevocably been announced in lae 995 ineres rae convergence had ended when he Euro was launched on This explains why he impac of ineres rae convergence on he German curren accoun was sronges beween 999 and 22 (accouning for abou + of he curren accoun/gdp raio). However, during ha ime he German curren accoun was sill negaive he curren accoun acually fell slighly beween 998 and 2. According o our esimaes, ineres rae convergence had a very small posiive effec on German GDP (due o sronger REA demand for German expors), uni labour cos and inflaion. The convergence of REA ineres raes o German levels had a markedly sronger negaive effec on he REA rade balance ineres rae convergence conribued especially o he sharp fall in REA ne expors in (see Figure 8.a). Ineres rae convergence also conribued o he boom in REA aciviy (see Figure 8.b). According o one prominen hypohesis, REA-German ineres rae convergence riggered a massive capial ouflow from Germany ha sharply lowered domesic German GDP and invesmen growh 8

21 (e.g., Sinn, 26, 2, 23). Our analysis does no suppor his view. The esimaed model does sugges ha ineres rae convergence lowered invesmen in Germany and raised he German curren accoun, bu only by a modes amoun. Also, he iming of ineres rae convergence does hus no mach he sharp rise in he German curren accoun--he laer occurred several years afer convergence. In closely relaed analyses, Hale and Obsfeld (23), in Veld e al. (23), Reis (23) and Fernández-Villaverde, Garicano and Sanos (23) argue ha he capial inflows experienced by Spain and oher Euro Area periphery counries were largely driven by ineres rae convergence. While our model esimaes show ha ineres rae convergence maered for he REA rade balance, we find ha oher shocks had an even more pronounced role for REA ne expors especially ROW demand shocks and domesic REA aggregae demand shocks (see below). (I should be noed ha he REA aggregae considered in he presen paper includes a broader se of counries han he periphery counries sudied by Hale and Obsfeld (23), in Veld e al. (23), Reis (23) and Fernández-Villaverde, Garicano and Sanos (23).) The hisorical decomposiion shows ha srong exernal demand (from he REA and he ROW) in he 2s conribued imporanly o he increase in he German curren accoun. In his period, German expors benefied from he boom in he REA and from srong ROW growh. In paricular, due o her srong rade links wih he new EU member saes, Germany benefied from he pos-accession booms in hose saes. In he 29 recession, he exernal demand conribuion urned abruply negaive. Since he crisis, lower ne expors o he slowly growing REA have been nearly fully offse by ne expor gains o he ROW. The posiive exernal demand shocks prior o he financial crisis essenially crowded ou German consumpion spending and invesmen. A he same ime, sronger exernal demand has increased German inflaion. Hence he effec of srong world demand is miigaed by is impac on German rade compeiiveness. 3 The cus in unemploymen benefis inroduced during he labour marke reforms raised German GDP, according o he model esimaes. The labour marke reforms raised household labour supply, and increased he German saving rae, bu only had a negligible effec on he invesmen rae. Due o he sluggishness of German aggregae demand, he labour marke reforms had a long-lasing posiive effec on he German curren accoun. The reforms conribued o a decline in uni labour coss, and hus increased German price compeiiveness. Spillovers of German labour marke reforms o REA real aciviy were very weak, bu he reforms made a negaive conribuion o REA ne expors. 4 The sizable rise in he old-age dependency raio (see bars labeled Reirees ) is anoher imporan shock o he German labor marke. In paricular, i amouns o a negaive labor supply shock i lowered GDP and he saving rae, due o he sluggishness of consumpion demand. Thus, posiive shocks o he number of reirees worsened he German curren accoun. By conras, as discussed in a Box below, a news shock ha raises he prediced fuure old-age dependency raio improves he curren accoun. The conribuion of shocks o he German firm financing wedge varies across he sample period. These shocks raised he German curren accoun in periods of elevaed financing coss, i.e. in he afermah of do-com bubble and of global financial crisis. During hose periods, firm financing shocks conribued o a fall on he German invesmen rae; hese shocks also ended o lower he German saving rae, bu markedly less han he 3 We simulaed a counerfacual scenario assuming independen moneary policy in Germany and a flexible exchange rae beween Germany and he REA. According o our esimaes, exernal demand from he ROW has benefied boh Germany and he REA (see below), and would hus only have had a minor effec on he German curren accoun, under a floaing exchange rae. 4 Figure 7.a also shows ha wage mark up shocks conribued slighly o he rise in he German curren accoun during he early 2s (due o a fall in he esimaed mark up). 9

22 invesmen rae. By conras, firm financing shocks lowered he curren accoun shorly before he financial crisis. Thus, shocks o firm financing coss do no explain he persisen German curren accoun improvemen. Unlike oher EA economies, Germany experienced a persisen fall in real house prices. The fall in German real house prices is mainly driven in he model by posiive shocks o risk premia on housing capial; hese shocks ighened he credi consrains of German non-ricardian households, riggered a fall in housing invesmen; his explains he persisen posiive conribuion of shocks o housing financing condiions o he German curren accoun surplus. The conribuion of German fiscal policy shocks o he German exernal surplus is esimaed o be minor over he sample. 5 Only in he las year is here a small posiive conribuion of he fiscal consolidaion o he rade surplus. Posiive Privae saving shocks (i.e. posiive shocks o he German subjecive discoun rae) accoun for an increasingly more imporan share of he German curren accoun surplus afer 23. Noe, especially, ha hese shocks explain more han half of he German curren accoun surplus afer 28. The negaive shocks o he German pension replacemen rae had a posiive bu much more modes effec on he German curren accoun, afer 26 (generaing roughly a rise of he German curren accoun of of GDP). Noe also ha he German Privae saving shock conribued o low German inflaion (as ha shock depressed aggregae demand in Germany). This shock has furhermore conribued negaively o German GDP and labour cos growh; i had a negaive effec on impor demand and a posiive impac on expors (due o exernal compeiiveness gains). As discussed in Secion 2, demographic projecions indicae ha, in he coming decades, he old-age dependency raio will rise furher markedly, while he replacemen rae will fall furher. Furhermore, over ime, projeced dependency raios has been revised upwards noiceably. For example, according o he 2 projecion of he German Federal Saisical Office, he prediced dependency raio (number of persons aged 65+ relaive o persons aged 2 o 64) in he year 24 was The projecion (for 24) was raised o 36.8, 38.7 and 39.2 in he 23, 26 and 29 projecions, respecively. (The Saisical Office publishes demographic projecions every hree years.). Noe ha we do no feed German demographic variables prediced beyond he sample period ino he model. Nor do we use informaion abou he successive revisions in demographic projecions. Hence, i seems plausible ha, by absracing from long-run demographic informaion, he esimaed model underesimaes he rue conribuion of German populaion ageing for he German curren accoun. I seems plausible ha he privae saving shock migh reflec demographic informaion ha is no capured by in-sample demographic daa. Ageing and pensions were he subjec of inense public debae, in Germany, around he urn of he cenury--hose debaes led o deep pension reforms, in 2-24 (see Box). These public debaes arguably raised awareness and concerns abou demographic issues in he German public. In addiion, he pensions reforms provided new ax incenives for privae pension saving our model absracs from hese ax incenives. Illusraive simulaions discussed in he Box below sugges ha an upward revision of long-erm demographic projecions has a sizable and persisen posiive effec on he German curren accoun. However, i would be echnically challenging o esimae a model varian wih shocks o long-run demographic informaion, i.e. wih demographic news 5 Oher empirical sudies (for a range of counries) oo repor small esimaes of he conribuion of fiscal shocks o he variance of he rade balance; see, e.g., Adolfson e al. (27). 2

23 shocks (especially as official demographic projecions are only released every hree years). We leave esimaion of such a model for fuure research. In summary, i seems plausible ha he shocks o he German discoun facor (ha accouns for a high share of he rise in he German curren accoun) migh reflec informaion on long-erm demographic rends ha is no capured by in-sample demographic daa. However, we canno precisely quanify he conribuion of hose long-erm demographic rends o he German curren accoun surplus. The esimaed negaive shocks o he German subjecive discoun rae may hus also capure oher adverse shocks o German consumpion demand. The major shocks ha increased he German curren accoun have ended o reduce REA ne expors (see Figure 8.a). For example, he German savings shocks had a large and persisen negaive effec on REA ne expors. This is due o he fac ha a reducion of German domesic demand has adverse effecs on REA real aciviy. In recen years, German labour marke reforms, oo, have ended o lower REA ne expors (due o he posiive effec of hose reforms on German price compeiiveness). German TFP shocks had persisen adverse effecs on REA ne expors unil he financial crisis however, afer he crisis, German TFP shocks have raised REA ne expors. Anoher imporan facor which has conribued o he fall in REA ne expors before he global financial crisis was he decline of he REA ineres rae spread which has noiceably simulaed REA aggregae demand. However, we also idenify an imporan auonomous REA aggregae demand componen, which especially over he period from 25 o 28 has conribued srongly o a worsening of he exernal balance--ha REA aggregae demand componen was mos likely associaed wih housing and asse booms in some REA counries. 6 Wih he collapse of hose booms, he emergence of REA banking problems and REA fiscal consolidaion, REA aggregae demand began o exer a less negaive effec on REA ne expors--and even has sared o conribue posiively o REA ne expors from he beginning of 22. As shown in Figure 8.a, ROW exernal demand flucuaions have also ended o boos REA ne expors, especially during he years 2-26, and in 22-3 (during his period ROW GDP growh noiceably exceeded REA and German growh). REA GDP was largely driven by domesic aggregae supply and demand shocks. The spillovers of German shocks o REA GDP are relaively weak. I can be noed ha REA and German aggregae supply shocks have ended o co-move posiively. By conras, Germany ended o experience negaive aggregae demand shocks before he crisis, whereas he REA mainly received posiive aggregae demand shocks, during ha period. The poorer performance of he REA economy compared o he German economy since he financial crisis is o a large degree driven by adverse REA aggregae demand shocks. Labour marke reform, oo, has conribued o he beer performance of Germany afer he crisis (he unemploymen rae has been falling in Germany afer he crisis, while unemploymen rose sharply in he REA). 6 Empirically, house price increases are ofen associaed wih a rade balance deerioraion (e.g., Aizenman and Jinjarak (23), Chinn e al. (23), European Commission (22a), Gee (2), Obsfeld and Rogoff (2)). The REA block of he model here absracs from housing (see above). As poined ou by a referee, he shocks o he REA subjecive discoun rae (assumed in he model) migh capure he effec of REA house price bubbles. 2

24 Box: Demographic news shocks and he German curren accoun Beween 2 and 29 we idenify a gradual increase of he conribuion of he Privae Savings shock on he German curren accoun surplus (see Figure 7.a). This box explores o wha exen his shock could reflec "demographic news" relaed o revised expecaions abou demographic rends and he cos of ageing. German pension reforms Demographic pressure became an imporan opic in he poliical debae in Germany and resuled in hree pension reforms (2, 23, 24) which raised awareness among he German populaion abou looming demographic problems. Imporanly, he pension reform in 2 consiued a regime shif in he German pension sysem. The so called 'Alersvermögensergänzungsgesez' or 'old-age wealh accumulaion law' (2) froze conribuions o he pay-as-you-go sysem by gradually reducing pension benefis and by providing ax subsidies for building up a hird pillar of he pension sysem (he so-called 'Rieser-Rene'). The aim of his reform was o gradually reduce he pension generosiy of he represenaive pensioner ('Eckrenner') from a ne replacemen rae of 7 in 2 o 68 in 23. However, i urned ou ha his reform was no sufficien o sabilize he German pension sysem. Two furher reforms lowered he generosiy of he pension sysem: (i) The 'Renenversicherung-Nachhaligkeigesez' or 'susainabiliy of pensions law' (23/24) inroduced a so-called susainabiliy facor which links fuure benefis o life expecancy and he employmen rae; he German Council of Economic Advisers (24) esimaed ha he susainabiliy facor will reduce pensions by 7.7 in 23. (ii) The 'Alerseinkünfegesez' or 'old-age income law' (24) phased-in he axaion of pension benefis; from 25, pensioners had o pay income axes on 5 of heir pensions; his share will rise o in 24. These hree pension reforms imply a combined decline of he pension replacemen rae by abou 2 unil 23 (Werding 23). News on demographic rends and he benefi replacemen rae Though i is difficul o quanify he public s awareness abou demographic pressures, regular demographic projecions by he German Saisical Office provide informaion abou revisions underaken by professional demographic forecasers in he 2s. As shown in Table B, he projeced old-age dependency raios for years afer 22 were markedly revised upwards beween 23 and 26. Table B: Germany Old-Age dependency raio projecions, various vinages (Number of persons aged 65+ relaive o persons aged 2 o 64 in ) projecion 25.4 : : : : 23 projecion : 27.5 : : : 26 projecion : : 3.7 : : 29 projecion : : : 33.7 : Assumpions: Feriliy rae.4, ne migraion p.a., baseline life expecancy. Source: German Federal Saisical Office, 9./././2. Bevölkerungsvorausberechnung 2/ 23/26/29 Modelling he effecs of demographic and pension news shocks 22

25 Boh he revisions on demographic projecions and he pension reforms signal a fall in fuure income o German households. Forward looking households should respond o his by increasing heir savings rae. To quanify he impac of ageing-relaed news shocks, we use our model o compue he perfec foresigh pah of German curren accoun implied by he 23 projecion of he German dependence raio for he years We compare ha baseline pah of he curren accoun o he pah implied by he 26 demographic projecion and by a gradual (linear) decline of he pension replacemen rae by 2 unil 23. (The pahs of he dependency raio and of he replacemen rae are assumed consan from 25 and 23, respecively). The firs line of he Table ( Scenario ) below shows he difference beween hese wo projeced curren accoun pahs (as a of GDP). Tha difference reflecs he effec of demographic news on he curren accoun. An addiional imporan aspec of demographic projecions relaes o he fiscal cos of ageing in erms of higher expendiure for healh and long erm care. The EU Commission s Ageing Repor (29) projecs ha hese old-age relaed fiscal expendiures will increase roughly by he same proporion as pension paymens. We ake accoun of his fiscal dimension of ageing by also considering an alernaive scenario ( Scenario 2 ) ha combines he news shocks abou he dependency raio and he replacemen rae wih he assumpion ha governmen consumpion rises gradually (linearly) by of GDP unil 25. This is a rough esimae (based on he 29 Ageing Repor) of exra ageing-relaed governmen consumpion implied by he demographic news shock. Because of heir adverse real income effecs, German households respond o he news shocks by increasing saving in order o smooh consumpion over ime. Habi persisence prevens a rapid adjusmen of he savings rae, and he curren accoun rises gradually by close o 3 of GDP over a period of 5 years, under Scenario. This sizeable effec is in he range of he esimaed conribuion of he privae savings shocks o he increase in he German curren accoun during he mid-2s, according o he hisorical decomposiion repored in Figure 7.a. The curren accoun response depends on he fiscal cos of ageing; in Scenario 2, he peak effec of he news shock on he curren accoun is abou sronger han in Scenario. Table B2: Impac of demographic news shock on he German curren accoun ( of GDP) Scenario Scenario Scenarios for he German exernal balance Alhough uncerainy abou fuure shocks makes i impossible o fully anicipae he furher evoluion of he German curren accoun, we can characerize he likely impac of curren drivers in he years o come. The conribuion of he German saving rae o he curren accoun is slowly falling. I is likely ha he savings rae will decline furher, given he fac ha high saving cohors (populaion aged beween 3 and 55) will decrease as a share of he oal populaion. A facor holding back a faser decline in saving could be precauionary savings relaed o he financial and sovereign deb crises. A furher facor ha migh conribue o a gradual fall in he curren accoun surplus is ha German residenial invesmen is likely o pick up in he near erm, given low real ineres raes in Germany. Alhough he radable conen of consrucion is low, his will raise 23

26 non-housing consumpion and hence reduce he curren accoun, due o he complemenariy beween housing and non-housing consumpion. The discussion above has focused on he reducion of benefi replacemen raes as a key elemen of he labour marke reforms of he early 2s. In he framework of our model, benefi reducion increases he labour supply. Due o he sluggish response of domesic demand, he labour supply expansion ranslaes iniially more ino real wage decline han higher employmen, which only increases gradually. The fall in wage and producion coss improves he price compeiiveness of German goods in foreign and domesic markes and improves he German curren accoun. However, he model suggess ha he posiive effec of permanen labour marke reform on he German curren accoun is only emporary, since employmen and associaed wage increases simulae domesic demand (privae consumpion). According o he model esimaes, he curren accoun increase reaches is maximum around 7 years afer he reform. Afer ha, he curren accoun declines gradually in response o growing domesic demand. This implies ha he conribuion of pas labour marke reforms o he curren accoun surplus is likely o fall in fuure years. In addiion he policy debaes in Germany abou he disribuional impac of he labour marke reforms has led o plans by he new German governmen o inroduce a minimum wage law which is likely o furher increase German wages. Moreover, srucural reforms currenly underaken in REA counries will boos REA growh and compeiiveness, and accelerae he erosion of Germany's compeiive advanage. The conribuion of fiscal policy shocks for he German curren accoun has been modes during he esimaion period. However, in view of he curren discussions in Germany abou he need o raise public infrasrucure invesmen, fuure fiscal policy oo may conribue o a reducion in he German exernal surplus. The German non-radables (services) secor lacks compeiion (barriers o enry ino he reail, crafs and healh secors), and i is someimes argued ha reforms boosing compeiion and produciviy in he German non-radables secor (services) would lower he German exernal surplus. The model here canno be used o evaluae ha view, as i does no include a non-radables secor. However, several recen papers have sudied he effecs of srucural reforms in he non-radables secor (modeled as a posiive shock o non-radables produciviy or a reducion in he mark ups changed by firms ha produce non-radables); see, e.g., Forni e al. (2), Vogel (2, 23) and Gomes e al. (23) who use rich DSGE models of open economies ha closely resemble he model used here. These analyses sugges ha reform in he non-radables secor has a srong posiive effec on GDP, bu ha he effec on ne expors is modes in fac, ne expors may acually rise. The reason for his is ha he domesic radable good producing secor uses non-radable inpus hence, measures ha boos he efficiency of he non-radables secor improve a counry s exernal compeiiveness. 7 7 Dusmann e al. (24) documen ha low wage growh in he German non-radables secor conribued o he compeiiveness of he German expors secor--more han 7 of he oal inpu used by he German expors secor are domesically produced. These srong domesic inpu linkages sugges ha an aggregaive model (wihou non-radables vs. radables disincion) may be suied for undersanding he German macroeconomy. 24

27 6. Conclusions We have developed a hree-counry DSGE model and esimaed ha model using quarerly daa for Germany, he res of he Euro Area (REA) and he res of he world (ROW). We used ha model o analyze he causes of Germany s subsanial and persisen curren accoun surplus, and is effec on he REA. Our resuls show ha simple mono-causal explanaions of he German surplus are insufficien. The surplus reflecs a succession of disinc shocks. According o our esimaes, he mos imporan facors driving he German surplus were posiive shocks o he German saving rae and o ROW demand for German expors, as well as German labour marke reforms and oher posiive German aggregae supply shocks. Those shocks had a noiceable negaive effec on REA ne expors, bu only a modes effec on REA real aciviy. We expec he conribuion of pas German labour marke reforms o he curren accoun surplus o decline in fuure years as wage growh picks up again. One policy conclusion from our analysis could be ha similar reforms were needed in EA defici counries. Srucural reforms in he REA will boos growh and improve exernal balances here, eroding Germany's compeiive advanage. As far as savings are concerned, illusraive model simulaions sugges increased awareness abou fuure demographic developmens and pension generosiy could explain a sizable and persisen posiive effec on he German curren accoun. To he exen ha his holds, i would no call for correcive policy acions. Regarding public demand, Germany's sound fiscal posiion provides space for a less resricive fiscal policy; he rise in German demand would reduce he exernal surplus and help o achieve a rebalancing in he EA, albei by a modes amoun. 25

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30 Lagarde, C. (22): Inerview wih Die Zei weekly newspaper (Dec. 27, 22). Lane, P. (22): "Capial flows in he Euro Area," Working Paper, Triniy College Dublin. Louanges, M. (25): "Is Germany on is way o regaining is European benchmark saus," PIMCO European Perspecives (Sepember 25). McCallum, B. (994): "A reconsideraion of he uncovered ineres pariy relaionship," Journal of Moneary Economics 33, Mendoza, E. (2): "Sudden sops, financial crises, and leverage," American Economic Review, Milesi-Ferrei, GM, A. Razin (998): "Sharp reducions in curren accoun deficis--an empirical analysis," European Economic Review 42, Obsfeld, M., K. Rogoff (996): "Foundaions of inernaional macroeconomics", MIT Press. Obsfeld, M. and K. Rogoff (2): "Global imbalances and he financial crisis: producs of common causes." In: Glick, R., Spiegel, M. (Eds.), Asia and he Global Financial Crisis. Federal Reserve Bank of San Francisco, San Francisco, pp Obsfeld, M. (22): "Does he curren accoun sill maer? American Economic Review 2, -23. Organisaion for Economic Co-operaion and Developmen (23): "Employmen and labor marke saisics." Pylarczyk, E. (25): "An esimaed DSGE model for he German economy wihin he euro area," Discussion Paper No 33/25, No 33/25. Rao M, W. Roeger and J. in Veld (29), QUEST III: an esimaed open-economy DSGE model of he Euro Area wih fiscal and moneary policy, Economic Modelling 26, Reis, R. (23): "The Poruguese slump-crash and he Euro-crisis," Brookings Papers on Economic Aciviy, Sinn, H-W. (23): "The laggard of Europe," CESifo Forum Vol. 4, Special Issue No.. Sinn, H.-W. (26): "The pahological expor boom and he bazaar effec: how o solve he German puzzle," The World Economy, Vol. 29, No. 9, pp Sinn, H.-W. (2): "Rescuing Europe," CESifo Forum, Vol., special issue, pp.-22. Sinn, H.-W. (23): "Jez hilf nur durchwurseln," ifo Sandpunk 5. Saisisches Bundesam (23): "9. Bevölkerungsvorausberechnung." Saisisches Bundesam (26): ". Bevölkerungsvorausberechnung." Saisisches Bundesam (29): ". Bevölkerungsvorausberechnung." Saisisches Bundesam (22): "2. Bevölkerungsvorausberechnung." U.S. Deparmen of he Treasury (23): "Repor o congress on inernaional economic and exchange rae policies." (Ocober 3, 23) Vogel, L. (2): "Srucural reforms and exernal rebalancing in he Euro Area: A modelbased analysis," European Economy, Economic Papers 433. Vogel, L. (23): "Nonradable secor reform and exernal rebalancing in Moneary Union: a model-based analysis," Working Paper, DG-ECFIN, European Commission. Werding, M. (23): "Alerssicherung, Arbeismarkdynamik und neue Reformen: Wie das Renensysem sabilisier werden kann," Berelsmann Sifung: Güersloh Wolf, M. (23): "Germany is a weigh on he world," Financial Times (November 5). 28

31 Figure : The German curren accoun, ne expors, consumpion and invesmen (.a) Curren Accoun, ne expors, ne ransfers and incomes from res of world, of GDP (.b) Inernaional Invesmen Posiion, of GDP 45 IIP ( of GDP) (.c) Naional saving, invesmen and CA, of GDP (.d) Privae & Governmen S & I, in of GDP (.e) Ne expor, Y-C-G, I, of GDP (.f) Privae & Governmen consumpion, of GDP (.g) Expors and Impors, of GDP (.h) Toal ne expors of Germany; German NX o REA; REA ne impors; EA ne expors 29

32 Figure 2: Real aciviy (DE: Germany) (2.a) Germany: real GDP & aggregae demand componens (2.b) YoY GDP growh raes (Germany, REA, ROW) = 95 Y 9 C G 85 I Figure 3: Ineres raes, inflaion, exchange raes (DE: Germany) (3.a) Nominal ineres raes: DE, REA, ROW, p.a. (3.b) YoY growh of GDP deflaor, (3.c) Nominal effecive exchange rae: DE vs. REA (3.d) Real exchange raes: DE-REA; DE-ROW Rise: DE apprecia.; exch. rae normalized a Rise: DE appreciaion 3

33 Figure 4: Wages, uni labor coss, unemploymen benefis (DE: Germany) (4.a) Nominal compensaion per employee, p.a. growh (4.b) Real compensaion per employee, p.a. growh (4.c) Nominal uni labor cos, DE & EA (25=) (4.d) Average unemploymen benefi raio, Germany Figure 5: Demographics and pensions: Germany (5.a) Germany, dependency raion, in (5.b) Germany, average pension replacemen rae, in 2-26: projecions (German Council of Economic Advisors (2)) 3

34 DE real GDP DE consumpion DE corporae invesmen DE rade balance of GDP DE employmen DE real wage DE/RoEA GDP deflaor RoEA real GDP RoEA domesic demand RoEA rade balance of GDP EA policy rae pp Euro/USD exchange rae Figure 6.a Posiive shock o German TFP Dynamic responses o a posiive sandard deviaion innovaion o German TFP are shown. Ineres rae responses ( p.a.) are expressed as differences from unshocked pah; rade balance responses are shown as differences from unshocked pah normalized by seady sae domesic GDP; responses of oher variables shown as relaive deviaions from unshocked pahs. A rise in he Euro/USD exchange rae corresponds o a Euro depreciaion. 32

35 DE real GDP DE consumpion DE corporae invesmen DE rade balance of GDP DE employmen DE real wage DE/RoEA GDP deflaor RoEA real GDP RoEA domesic demand of GDP RoEA rade balance pp EA policy rae Euro/USD exchange rae Figure 6.b Posiive shock o German invesmen efficiency (producion capial) Dynamic responses o a posiive sandard deviaion innovaion o German invesmen efficiency (producive capial) are shown. Ineres rae responses ( p.a.) are expressed as differences from unshocked pah; rade balance responses are shown as differences from unshocked pah normalized by seady sae domesic GDP; responses of oher variables shown as relaive deviaions from unshocked pahs. A rise in he Euro/USD exchange rae corresponds o a Euro depreciaion.

36 DE real GDP DE consumpion DE corporae invesmen of GDP DE rade balance DE employmen DE real wage DE/RoEA GDP deflaor RoEA real GDP RoEA domesic demand of GDP RoEA rade balance pp EA policy rae Euro/USD exchange rae Figure 6.c Cu in German unemploymen benefi raio Dynamic responses o a permanen percenage poin reducion in he German unemploymen benefi raio are shown. Ineres rae responses ( p.a.) are expressed as differences from unshocked pah; rade balance responses are shown as differences from unshocked pah normalized by seady sae domesic GDP; responses of oher variables shown as relaive deviaions from unshocked pahs. A rise in he Euro/USD exchange rae corresponds o a Euro depreciaion.

37 DE real GDP DE consumpion DE corporae invesmen of GDP DE rade balance DE employmen DE real wage DE/RoEA GDP deflaor.2 RoEA real GDP RoEA domesic demand RoEA rade balance of GDP EA policy rae.2 Euro/USD exchange rae pp Figure 6.d Posiive German saving shock (fall in subjecive rae of ime preference) The Figure shows dynamic responses o a negaive sandard deviaion innovaion o he rae of ime preference of German households. Ineres rae responses ( p.a.) are expressed as differences from unshocked pah; rade balance responses are shown as differences from unshocked pah normalized by seady sae domesic GDP; responses of oher variables shown as relaive deviaions from unshocked pahs. A rise in he Euro/USD exchange rae corresponds o a Euro depreciaion.

38 DE real GDP DE consumpion DE corporae invesmen DE rade balance of GDP DE employmen.8.6 DE real wage DE/RoEA GDP deflaor RoEA real GDP RoEA domesic demand of GDP RoEA rade balance pp EA policy rae Euro/USD exchange rae Figure 6.e Posiive shock o German governmen consumpion Dynamic responses o a posiive of GDP innovaion o German governmen consumpion are shown. Ineres rae responses ( p.a.) are expressed as differences from unshocked pah; rade balance responses are shown as differences from unshocked pah normalized by seady sae domesic GDP; responses of oher variables shown as relaive deviaions from unshocked pahs. A rise in he Euro/USD exchange rae corresponds o a Euro depreciaion.

39 DE real GDP DE consumpion DE corporae invesmen DE rade balance of GDP DE employmen DE real wage DE/RoEA GDP deflaor RoEA real GDP RoEA domesic demand RoEA rade balance of GDP pp EA policy rae Euro/USD exchange rae Figure 6.f Posiive shock o German governmen invesmen Dynamic responses o a posiive of GDP innovaion o German governmen invesmen are shown. Ineres rae responses ( p.a.) are expressed as differences from unshocked pah; rade balance responses are shown as differences from unshocked pah normalized by seady sae domesic GDP; responses of oher variables shown as relaive deviaions from unshocked pahs. A rise in he Euro/USD exchange rae corresponds o a Euro depreciaion.

40 DE real GDP DE consumpion DE corporae invesmen.7 of GDP DE rade balance DE employmen DE real wage DE/RoEA GDP deflaor RoEA real GDP RoEA domesic demand RoEA rade balance of GDP pp EA policy rae Euro/USD exchange rae Figure 6.g Fall in REA-German risk premium The Figure shows dynamic responses o a negaive percenage poin innovaion o difference beween REA bonds and German bonds. Ineres rae responses ( p.a.) are expressed as differences from unshocked pah; rade balance responses are shown as differences from unshocked pah normalized by seady sae domesic GDP; responses of oher variables shown as relaive deviaions from unshocked pahs. A rise in he Euro/USD exchange rae corresponds o a Euro depreciaion.

41 DE real GDP DE consumpion DE corporae invesmen DE rade balance of GDP DE employmen DE real wage DE/RoEA GDP deflaor RoEA real GDP RoEA domesic demand of GDP RoEA rade balance pp EA policy rae Euro/USD exchange rae Figure 6.h Res-of-world aggregae demand shock The Figure shows dynamic responses o a persisen sandard deviaion increase in he subjecive discoun rae of ROW agens. Ineres rae responses ( p.a.) are expressed as differences from unshocked pah; rade balance responses are shown as differences from unshocked pah normalized by seady sae domesic GDP; responses of oher variables shown as relaive deviaions from unshocked pahs. A rise in he Euro/USD exchange rae corresponds o a Euro depreciaion.

42 Figure 7. Hisorical decomposiions of German macroeconomic variables 7.a. German curren accoun divided by nominal GDP q q _ Technology Labour wedge Unemploymen benefi Reirees Pension replacemen rae Privae saving Fiscal policy Firm finance wedge Housing financing condiions REA risk premium Exernal demand and rade Ohers b. German saving divided by nominal GDP q q _ Technology Labour wedge Unemploymen benefi Reirees Pension replacemen rae Privae saving Fiscal policy Firm finance wedge Housing financing condiions REA risk premium Exernal demand and rade Ohers c. German nominal invesmen divided by nominal GDP q q _ Technology Labour wedge Unemploymen benefi Reirees Pension replacemen rae Privae saving Fiscal policy Firm finance wedge Housing financing condiions REA risk premium Exernal demand and rade Ohers

43 Figure 7 coninued 7.d. German real GDP, year-on-year growh rae y y _ Technology Labour wedge Unemploymen benefi Reirees Pension replacemen rae Privae saving Fiscal policy Firm finance wedge Housing financing condiions REA risk premium Exernal demand and rade Ohers e. German inflaion (year-on-year growh of GDP deflaor) yea o yea _ Technology Labour wedge Unemploymen benefi Reirees Pension replacemen rae Privae saving Fiscal policy Firm finance wedge Housing financing condiions REA risk premium Exernal demand and rade Ohers Noe: The lines wih black lozenges show he hisorical daa. Thin horizonal line represens seady sae values. Verical bars show conribuions of differen ypes of shocks o he hisorical daa. Verical bars above he horizonal (seady sae) line represen posiive shock conribuions o he hisorical daa., while bars below he horizonal line represen negaive conribuions. Sum of conribuions of all shocks equal he hisorical daa. Conribuions of he following (groups of) exogenous shocks originaing in Germany are ploed: () TFP and invesmen efficiency (bars labeled echnology ); (2) Wage mark-up ( Labour wedge ); (3) Unemploymen benefi raio ( Unemploymen benefi ); (4) Old-age dependency raio ( Reirees ); (5) Pension replacemen rae; (6) Subjecive rae of ime preference ( Privae saving ); (6) Fiscal policy; (7) Firm finance wedge; (8) Household loan-ovalue raio and risk premium on housing capial ( household financing condiions ). In addiion, we show he conribuion of disurbances o: () REA-German ineres rae spread ( REA risk premium ); (2) shocks originaing in he REA and ROW, and shocks o he relaive preference for German vs. impored goods ( Exernal demand and rade ). The remaining shocks are combined ino a caegory labeled Oher shocks. 4

44 Figure 8. Hisorical decomposiions of REA macroeconomic variables 8.a REA ne expors divided by nominal GDP.5 q q _ REA domesic demand REA domesic supply Technology Labour wedge Unemploymen benefi Reirees Pension replacemen rae Privae saving Fiscal policy Firm finance wedge Housing financing condiions REA risk premium REA Exernal demand and rade Ohers b REA GDP, year-on-year real GDP growh rae REA domesic demand REA domesic supply Technology Labour wedge Unemploymen benefi Reirees Pension replacemen rae Privae saving Fiscal policy Firm finance wedge Housing financing condiions REA risk premium REA Exernal demand and rade Ohers Noe: The lines wih black lozenges show he hisorical daa. Thin horizonal line represens seady sae values. Verical bars show conribuions of differen ypes of shocks o he hisorical daa. Verical bars above he horizonal (seady sae) line represen posiive shock conribuions o he hisorical daa, while bars below he horizonal line represen negaive conribuions. Sum of conribuions of all shocks equal he hisorical daa. Conribuions of () REA domesic demand shocks, and (2) REA domesic supply shocks are ploed. In addiion, we show he conribuions of he following shocks originaing in Germany: () TFP and invesmen efficiency (bars labeled echnology ); (2) Wage mark-up ( Labour wedge ); (3) Unemploymen benefi raio ( Unemploymen benefi ); (4) Old-age dependency raio ( Reirees ); (5) Pension replacemen rae; (6) Subjecive rae of ime preference ( Privae saving ); (6) Fiscal policy; (7) Firm financing wedge; (8) Household loan-o-value raio and risk premium on housing capial ( household financing condiions ). Also shown are he conribuions of: () REA-German ineres rae spread ( REA risk premium ); (2) shocks originaing in he ROW, and shocks o he relaive preference for REA goods vs. goods impored by he REA ( REA exernal demand and rade ). The remaining shocks are combined ino a caegory labeled Oher shocks. 42

45 APPENDICES A. Deailed model descripion B. Observables and daa sources C. Economeric mehodology and esimaion resuls D. Sensiiviy analysis A. Model descripion The model is an exension of he QUEST model esimaed on euro area daa by Rao e al. (29), and similar model versions have been esimaed on Spanish daa (in' Veld e al., 22) and on US daa (in' Veld e al., 2). We consider a hree-region se-up wih Germany, he res of he euro area (REA) and he res of he world (RoW). The German block of he model is raher deailed, while he REA and RoW blocks are more sylized. The German block assumes wo represenaive households: One household has a low rae of ime preference and holds financial asses ( saver household ). The oher household has a higher rae of ime preference, and borrows from he saver household using her housing sock as collaeral. We assume ha he loan-o-value raio (raio of borrowing o he value of he collaeral) flucuaes exogenously, and ha he collaeral consrain binds a all imes. Boh households provide labour services o goods producing firms, and hey accumulae housing capial. Worker welfare depends on heir consumpion, hours worked and sock of housing capial. The paien household owns he German goods producing secor and he consrucion secor; in equilibrium, he paien household also holds financial asses (governmen deb, foreign bonds). German firms maximize he presen value of he dividend sream paid o he paien (capialis) household. We assume ha German firms ren physical capial from saver households a a renal rae ha equals he risk-free ineres rae plus an exogenous sochasic posiive wedge; ha wedge hence creaes a gap beween he marginal produc of capial and he risk-free ineres rae. German firms expor o he REA and he RoW. The producion echnology allows for variable capaciy uilizaion and capial and labour adjusmen coss. Household preferences exhibi habi formaion in consumpion. These model feaures help o beer capure he dynamics of he curren accoun and oher macro variables of he German economy. The German block also assumes a governmen ha finances purchases and ransfers using disoring axes and by issuing deb. The German block assumes exogenous shocks o preferences, echnologies and policy variables ha aler demand and supply condiions in markes for goods, labour, producion capial, housing, and financial asses. The models of he REA and RoW economies are simplified srucures wih fewer shocks; specifically, he REA and RoW blocks each consis of a New Keynesian Phillips curve, a budge consrains for a represenaive household, demand funcions for domesic and impored goods (derived from CES consumpion good aggregaors), and a producion echnology ha use labour as he sole facor inpu. The REA and RoW blocks absrac from producive capial and housing. In he REA and he RoW here are shocks o labour produciviy, price mark ups, and he subjecive discoun rae, as well as moneary policy shocks, and shocks o he relaive preference for domesic vs. impored consumpion goods. The behavioral relaionships and echnology are subjec o auocorrelaed shocks denoed by k U, k k where k sands for he ype of shock. The logarihm of u lnu will generally follow an AR() k k process wih auocorrelaion coefficien ρ and innovaion ε. 8 The following secions describe he 8 Lower cases denoe logarihms, i.e. z ln Z. Lower cases are also used for raios and raes. In paricular, we j j define p P / P as he relaive price of good j w. r.. he GDP deflaor. Domesic variables are wihou 43

46 modelling of he Germany block of he model, exernal linkages and he REA and RoW pars in deail. A.. Firms A... Final goods producers Firms operaing in he final goods producion secor are indexed by j. Each firm produces a variey of he domesic good which is an imperfec subsiue for varieies produced by oher firms. Because of imperfec subsiuabiliy, firms are monopolisically compeiive in he goods marke and face a downward-sloping demand funcion for goods. Domesic final good producers sell he goods and services o domesic and foreign households, invesmen and consrucion firms and governmens. j Oupu is produced wih a Cobb-Douglas producion funcion using firm capial K, employmen and public infrasrucure KG as inpus and he TFP scaling facor A : j j j Y j G () Y = A( ucap K ) α ( U L) α ( KG) α. Y The economy-wide labour-augmening produciviy shock u follows a random walk wih drif. j Employmen a he firm level L is a CES aggregae of labour supplied by individual householdsi : θ θ θ i, j θ j (2) L L di. where θ > deermines he degree of subsiuabiliy beween differen ypes of labour. The firms also j decide abou he degree of capaciy uilizaion ( ucap ). The oupu of he final goods secor Y is a CES aggregae of he oupu of individual firms j : η η η j η (3) Y Y dj, where η indicaes he degree of subsiuabiliy beween he varieies j ha deermines he seadysae price mark-up of final goods and gives he demand for individual varieies as: j j (4) Y = ( p ) η Y. j The firms inves I ino producive capial. The capial sock evolves according o: (5) K j j ( K ) j = I + δ K K wih δ being he rae of capial depreciaion adjused by rend populaion and produciviy growh. The firms face echnological and regulaory consrains ha resric he price seing, employmen, invesmen and capaciy uilizaion decisions. The following convex funcional forms are chosen: P j j 2 adj ( P ) = γ P( P ) Y 2 L j j 2 adj ( L) = γ L( L) w (6) 2. j i j I K 2 I j 2 I adj ( I ) = γk( δ ) p K + γi( I ) p 2 K 2 ucap j j j 2 I j adj ( ucap ) = ( γ ( ucap ) + γ ( ucap ) ) p K ucap, ucap,2 The objecive of he firm is o maximize he sream of expeced afer-ax ( K ) profis: j L regional superscrip. We use he superscrip W for variables relaing o he res of he world (ROW) and EA for variables relaing o he euro area. 44

47 r β K j j j K I j I j j (7) Ε (( )( py wl) + δ p K p I adj ), where I U β = p he uni price of capial insallmen and adjusmen coss are: j P j L j I j ucap j (8) adj adj ( P ) + adj ( L) + adj ( I ) + adj ( ucap ). In each period of ime, firm j decide abou capial, invesmen, labour demand, capaciy uilizaion and produc prices opimally given he producion echnology, adjusmen coss and he demand funcion for firm oupu. The firs-order condiions from he maximizaion of (7) under () and (4)-(6) are: j j I j j j εy k δ p+ j (9) q + ( ucap )( γucap, + γucap,2 ( ucap )) = ( α) + I j δ + E k q I + pk + r p j I j I () K j γ I p+ j q = + γk( δ ) + γ j I I E r I I + K + r p j j K w εα () Y j γ L j ( ) w( + u ) = γ Lw L + E( w L ) j r + + L + r j j εy j j (2) ( α) = ucap ( γucap, + 2 γucap,2 ( ucap )) I j pk j K ε γ P j j Y + j (3) ε = ( )( ( + u )) ( ( sfpeπ ( sfp) π ) E π ) r + +, η η + r Y j where w is he real wage, ε is he inverse of he seady-sae price mark-up and sfp he degree of forward-looking behavior among price seers in forming inflaion expecaions. A..2. Residenial consrucion Monopolisically compeiive firms h in he residenial consrucion secor use new land (Ricardian) households and final goods /( ) σ L L L σl σ σ H σl L σl σl Con σl = L + ( L) Con J o produce new houses wih a CES echnology: L I sold by (4) I s I s I The providers of consrucion services are monopolisically compeiive and face quadraic price adjusmen coss: Con Con Con 2 (5) adj ( P ) = γ Con( P ). 2 The sock of available land is deermined by he exogenous growh of land supply less he use of land in curren consrucion: L gl L (6) Land = ( + g + u ) Land I The firs-order condiions for he demand for consrucion services and land and for he pricing of hese inpus and he produced houses are: L L L P σ L H (7) I = s ( ) I H P Con Con L P σ L H (8) I = ( s )( ) I H P Con pcon Con Con Con Con Con (9) p = + u γcon( ( sfp Eπ ( sfp ) π ) π ) r r L l p (2) + + r E = p L L gl + g + u 45

48 (2) where p = ( s ( p ) + ( s )( p ) ) H L σl Con σl /( σl) L L Con sfp is he degree of forward-looking behavior in he formaion of consrucion price l expecaions and r he real reurn on land. New and exising houses are perfec subsiues. Households can make capial gains or suffer capial losses depending on house price flucuaions. A..3. Invesmen goods producers There is a perfecly compeiive invesmen goods producion secor which combines domesic and foreign final goods, using he same CES aggregaor as privae consumpion (see below), o produce invesmen goods for he domesic economy. Denoe he CES aggregae of domesic and foreign inp inpus used by he invesmen goods secor wih I, hen real oupu of he invesmen goods secor is produced by he following linear producion funcion: inp PI (22) I = I U PI in which U is a echnology shock specific o he producion echnology for invesmen goods, PI PI PI which follows a random walk u = u + ε. The price of invesmen goods relaive o consumpion goods follows as: I PI C (23) pu = p. A.2. Households The household secor consiss of a coninuum of households i [;]. The fracion r s of he r households is Ricardian and indexed by he superscrip r ; he fracion s is credi-consrained households indexed by he superscrip c. Period uiliy has he same funcional form for boh ypes of households. I is specified as nesed CES i i i aggregae of consumpion ( C ) and housing services ( H ) plus uiliy from leisure ( L ). We also C allow for habi persisence in consumpion ( h ). The emporal uiliy for household i is given by: σ σ H σ H σ H i C i σ H H i i i C hc σ i σh i σh UC (, H, L) = ( sh) H C + (24) σ h ϑ L i κ PTOT σ + U ( RETIR YOUNG L) ( U ) κ where σ is he inverse of he ineremporal elasiciy of subsiuion, RETIR is he exogenous populaion share of reired persons and YOUNG is he exogenous populaion share of young persons and: ( )/ ( )/ (25) ( U PTOT ) α + αg α Y ( PI = U U ) α α a scaling facor for balanced growh. Households supply differeniaed labour services L i ha are assumed o be equally disribued across Ricardian and credi-consrained households. A.2. Ricardian households Ricardian households have full access o financial markes. These households hold domesic, governmen bonds ( B ) and bonds issued by oher domesic and foreign households ( B, B F DE ) 9, G r 9, Ne foreign asses ( F DE F, RE B and analogously B ) denominaed in RoW currency (here, USD); RE p are, respecively, he RoW and REA GDP deflaors relaive o DE GDP prices. ep RW and 46

49 domesic corporae shares ( S ), he sock of land ( Land ) sill available for building new houses and par of he housing sock ( H ). In addiion, Ricardian households keep bank deposis ( D ). There r are specific risk premia aached o he differen asses. The Ricardian households receive labour income, reurns o financial asses, revenue from selling land o he residenial consrucion secor and profi income from he firms owned by he households. Profi income of final-goods producers is paid as dividend o shareholders. Profi income from he H B consrucion secor is Pr, and profi income from banks is Pr. 2 All domesic firms are owned by domesic Ricardian households. The households consume final goods, inves ino residenial propery and supply labour. The governmen levies social securiy conribuions on labour income ( ssc ) and lump-sum axes ( TAX ), axes labour income ( W ) and household final demand ( C ) and pays lumpsum ransfers ( TR ). The Ricardian budge consrain in real erms wih all prices expressed relaive o he domesic GDP deflaor is: C C r C H H, r r G RW F, DE r j L ( + ) p C + ( + ) p I + B + B + e p B + D + S + p Land (26) j= + adj W + adj I = + r B + + r rprem B W i H Hr, c r b b G ( ) ( ) ( ) ( ) + ( + r rprem ) e p B + ( + r rprem ) D + ( + r rprem ) S RW RW, DE RW F, DE d, r d r r k k j j= + ( + r rprem ) p Land + p I + PR + PR + ( ssc ) w L + TR TAX l l L L L H B W ir, r + BEN ( RETIR YOUNG NPART L ) Wage adjusmen and he invesmen decisions w.r.. housing are subjec o convex adjusmen coss: i W i W 2 i adj ( W ) = γ W( ) W i 2 W (27) Hr, H Hr, I H 2 H r Hr, 2 H adj ( I ) = γh ( δ ) p H γih( I ) p r + 2 H 2 The sock of housing owned by Ricardian households follows: r Hr, H r (28) H = I + ( δ ) H. r β r r r The Ricardian households maximize welfare Ε UC (, L, H ) as he discouned sum of U β = expeced period uiliy subjec o he consrains (26)-(28). The discoun facor U β r β is subjec o random shocks ha add exogenous changes o he ineremporal consumpion pah. Welfare maximizaion gives he sandard firs-order opimaliy condiions for consumpion, demand for housing, residenial invesmen and asse holding decisions by he Ricardian household: r β C C r UC, + U ( + + ) p+ (29) β E = E r r C C U + r ( + ) p (3) (3) C, C r H C H Hr, p U H, δ ( + + ) p+ Hr, = + H r hr, C H + p UC, + r ( + ) p Hr, H Hr, I H Hr, p+ Hr, = + γh ( δ ) + γ r Ih γ r Ih H + H + r p q E q q I E E I 2 Banks ake deposis from Ricardian and credi-consrained households, pay ineres on deposis and ransfer he operaing profi o heir Ricardian owners. As banks do no play a fundamenal role in financial inermediaion beween households and firms or beween Ricardian and credi-consrained households in he underlying model version, he paper absains from a deailed descripion of banks. 47

50 For asse holdings he no-arbirage condiions ogeher wih he definiion of he asse-specific risk premia give: b r b b B ar (32) r = r + rprem + ω ( by ) 4Y (33) (34) (35) d r d dr, r r = + ω r r rprem ( C / D ) κd r = r + u h, r r rpremh r = r + rprem + u k r k rpremk L l r l L p Land (36) r = r + rprem ( val ) Y (37) (38) (39) B B r r E E rprem u FDE, FRE, r EA EA e rpremde = + π+ π+ ( ) + RW Y s B B r r E E rprem u de FRE, FDE, RE EA EA RE e rpremre = + π+ π+ ( ) + de RW s Y e s B + B r r E E E rprem u de FDE, FRE, EA RW RW EA + e rpremea = + π+ π + + ( ) ( ) + de RW e s Y EA EA RE RW where r is he policy rae in he euro area in real erms, π, π and π is GDP price inflaion de in he euro area aggregae, he REA and he RoW, s is he share of Germany in euro area GDP, e is he EUR/USD nominal exchange rae, and B is he NFA posiion of he REA. The deb-elasic F, RE ineres rae premium on households induces saionariy in he NFA posiion (e.g., Kollmann, 22). The ineres elasiciy w.r.. he NFA posiion is also an imporan behavioral parameer in our analysis as i describes he risk olerance of foreign crediors. A.2.2 Credi consrained households Credi-consrained households differ from Ricardian households in wo respecs: hey have a higher c r rae of ime preference ( β < β ), and hey face a collaeral consrain on heir borrowing. They c borrow B exclusively from domesic Ricardian households. The budge consrain of credi-consrained households in real erms wih all prices expressed relaive o he domesic GDP deflaor is: (4) ( + ) p C + ( + ) p I + ( + r ) B + D + adj ( W ) + adj ( I ) = B + TAX C C c C H Hc, c c c W i H H,c c d c W ic, c ( ) ( ) ( ) + TR + + r D + ssc w L + BEN RETIR YOUNG NPART L wih wage adjusmen coss as in (27) and adjusmen coss on housing invesmen: Hc, H H,c I H 2 c Hc, 2 (4) adj ( I ) = γh ( δ ) H Ih( I ) c + γ 2 H 2 The sock of housing owned by credi-consrained households evolves according o: c H,c H c (42) H = I + ( δ ) H The collaeral consrain deermines he borrowing capaciy of he credi-consrained households:,, (43) ( + r c ) c dc ( c ) c ( dc ) c ( H ( )) c B = ρ + r B + ρ χ E p+ + π+ H where he loan-o-value raio ha is imposed by Ricardian lenders is subjec o a sochasic shock c c χ = χ + u χ. 48

51 c β c c c The credi-consrained households maximize welfare Ε UC (, L, H ) as he discouned U β = sum of expeced period uiliy subjec o he consrains (4)-(43). The firs-order condiions for consumpion and housing are: c β c C C c UC, + U ( ( + r ) ψ ) ( + + ) p+ (44) β E = E c c dc, C C U ( + r )( ρ Eψ ) ( + ) p (45) (46) C, + I ( + r ) ψ p q I E E I H,c c H H,c H H,c + Hc, = + γh ( δ ) + γih γ c c dc, Ih H + H ( + r )( ρ Eψ+ ) p U q E q E C c c H C H dc, H,c p H, ( ( + r ) ψ)( δ ) ( + + ) p+ H,c ( ρ ) ψ c H = + H c hc, dc, C H + + C χ π + p UC, ( + r )( ρ Eψ+ ) ( + ) p + c where ψ is he Lagrange muliplier of he collaeral consrain. The ineres rae for collaeralconsrained households is: (47) r c = ( s d ) r r + sr d d Furhermore we have r = r + u and h, c c rpremh r = r ω ( C / D ) κd, where he laer is analogous d r dc, c c o (33) for Ricardian households and pins down he deposi holding by credi-consrained consumers. A.2.3 Wage seing Trade unions are maximizing a join uiliy funcion for each ype of labour i. I is assumed ha ypes of labour are disribued equally over Ricardian and credi-consrained households wih heir respecive populaion weighs. Nominal rigidiy in wage seing is inroduced in he form of adjusmen coss for changing wages. The wage adjusmen coss are borne by he household. The rade unions se wages by maximizing a weighed average of he uiliy funcions of Ricardian and credi-consrained households. The wage rule is obained by equaing a weighed average of he marginal uiliy of leisure o a weighed average of he marginal uiliy of consumpion imes he real wage adjused for a wage mark-up: (48) ρ r r r c w L, ( s ) U L, C C W ( + ) p ( ) ( ssc ) w r r r c BEN suc, ( s ) U C, θ su + ( ) + W γw W = ( )(( ssc) w BEN) + w( π ( sfw) π ) θ θ γw W w( Eπ ( sfw) π)) r + + r θ The wage mark-up flucuaes around /θ, which is he inverse of he elasiciy of subsiuion beween differen varieies of labour services. Flucuaion in he wage mark-up arises because of wage adjusmen coss (27). Real benefis in GDP prices equal he replacemen rae rimes he real wage: U (49) BEN = b w The raio of he marginal uiliy of leisure o he marginal uiliy of consumpion is a naural measure of he reservaion wage. If he raio is equal o he consumpion wage ne of benefi paymens o nonworking pars of he labour force, he household is indifferen beween, on he one hand, supplying an addiional uni of labour and spending he addiional income on consumpion or, on he oher hand, no increasing labour supply. The specificaion (48) also allows for real wage ineria ρ w. Uni labour coss are ulc = wl / Y, which equals he wage share in domesic income. A. 3 Trade and he curren accoun In order o faciliae aggregaion we assume ha households, invesmen goods producers and he governmen have idenical preferences across goods used for privae consumpion, public expendiure ρ w 49

52 ni, ni, ni, Gn, and invesmen. Le Z { C, I, C } be demand by an individual household, invesmen good producer or he governmen in counry n = DE, RE, RW. Then heir preferences are given by he uiliy funcion: (5) n M Z = ( s u ) ( Z ) + ( s + u ) ( Z ) n M n n n n M M M M σ σ ni, dn, M, n σ dni,, σ d, n M, n σ f, ni, σ n M n M σ /( σ ) dni,, f, ni, where Z and Z are indexes of demand across he coninuum of differeniaed goods produced dn, in he domesic economy and abroad, respecively. The home bias parameer s can be subjec o, random shocks u M n. Households, firms and governmens in counry/region n have preferences over impors from counry/region m given by σ n n /( σ ) n σ n n f, n nm, σ (5) f, nm, σ Z = ( s ) Z m f, nm, where Z are indexes of demand across he coninuum of differeniaed goods produced in nm, exporing regions m, and s is he bilaeral impor share parameer. n n The elasiciy parameers σ M and σ deermine he price elasiciy of bilaeral impors. In general we find ha goods and services produced in Germany and he REA are closer subsiues o each oher, while goods produced in he RoW are sronger complemens o goods produced in he EA. This is refleced by DE RE RW RW σ, σ < and by σ > and σ M <. German exporers buy final domesic goods X and ransform hem ino exporable goods using a linear echnology, so ha expor prices are given by: X, DE (52) p = PX x X, DE x X, DE X, DE r, u γpx ( sfp Eπ + + ( sfp ) π π ) / ( + r ) PX where u is a price seing shock, γ Px quanifies price adjusmen coss and sfpx is he degree of PX forward-looking in expecaions. For he REA and he RoW we se u = and γ Px =, so ha he X, RE RE X, RW RW regions' expor prices p = p and p = p. Imporers buy foreign goods a quaniy M from foreign exporers and sell hem on he domesic marke, charging he domesic currency price: DE DE DE DE, RE X, RE σ DE, RW X, RW σ /( σ ) M, DE ( s ( p ) + s ( ep ) ) (53) p = PM, DE m M, DE m M, DE M, DE r, u γpm( sfp Eπ + + ( sfp ) π π )/( + r ) whereu PM is a price seing shock, γ Pm quanifies price adjusmen coss and sfpm is he degree of PM forward-looking in expecaions. For he REA and RoW we se u = and γ = o obain: (54) (55) p M, RE e p M, RW RE RE RE RE, DE X, DE σ RE, RW X, RW σ /( σ ) + ep, PM, RE u RW RW RW RW, DE X, DE σ RE, RW X, RW σ /( σ ) ( s ( p ) + s ( p ) ) PM, RW u ( s ( p ) s ( ) ) = = German impor demand allows for some ineria in demand adjusmen ( ρ ) and is given by:, m Pm 5

53 (56) DE γ DE M m DE M DE d, DE M, DE p σ M M γ = I G s + u C I G p p p p p + C + C + C + C p p p p ( )( ) ( ) C I G C I G For REA and RoW impors we have analogous expressions: (57) RE γ RE M, RE m RE RE d, RE M, RE σ M γ = d, RE s + u C, RE d, RE M p M ( )( ) ( ) Y p Y RW γ RW M, RW m RW RW d, RW M, RW σ M = d, RW s + u C, RW d, RW M p M RW γ (58) m ( )( ) ( ) Y p Y d where Y is domesic demand in he REA and RoW, respecively, as defined below. Expors of reach region are deermined by he impor demand of he oher regions: DE RE, DE RW, DE X = M + M (59) RE DE, RE RW, RE X = M + M RW DE, RW RE, RW X = M + M wih bilaeral impor demand: X, RE DE DE, RE DE, RE p σ DE (6) M = s ( ) M M, DE p X, RW DE DE, RW DE, RW ep σ (6) M = s ( ) M M, DE p X, DE RE, DE RE, DE p σ (62) M = s ( ) M, RE p X, RW,, ep σ (63) M = s ( ) M, RE p RE M RE RE M DE RE RW RE RW RE X, DE RW, DE RW, DE p σ (64) M = s ( ) M, RW ep RW M RW X, REW RW RW, RE RW, RE p σ RW (65) M = s ( ) M M, RW e p Consumer prices relaive o he GDP deflaor follow from (5) as: (66) p s u p s u U Real GDP in Germany equals he sum of is componens: C G G I Con Con G (67) Y = p C + p C + p I + p ( I + I ) + TB,,,,, /( ) (( )( ) DE DE C d DE M DE M σm d DE M DE σm Pc = + + ( )) DE X, DE DE M, DE DE where TB p X p M is he rade balance. The curren accoun is he sum of ne invesmen income from abroad, he rade balance and he ransfer accoun ( TA ): DE RW RW F, DE DE DE (68) CA r ep B + TB + TA The ne inernaional invesmen posiion (NIIP) equals he cumulaed curren accoun plus valuaion effecs:,,,, (69) e RW F DE ( RW ) RW F DE DE DE ( BWREV DE BW DE p B = + r ep B + TB + TA + u + u ) Y DE I Con Con G Economy-wide savings correspond o S CA + p I + p ( I + I ). RE m DE m 5

54 A.4. Policy Governmen expendiure and receips can deviae emporarily from heir long-run levels in sysemaic response o budgeary or business-cycle condiions and in response o idiosyncraic shocks. Concerning governmen consumpion and governmen invesmen, we specify he following auoregressive equaions: G G C G CG C G B B ar DEF B ar CG (7) C = τlag ( C ) τ ( by ) τ ( def ) + u PTOT PTOT U U 4Y Y G G I G IG I G IG (7) I = τ Lag ( I ) + u PTOT PTOT U U Governmen consumpion reacs o he level of governmen deb and he governmen defici relaive ar ar o he associaed deb and defici arges by and def. The price level of governmen consumpion may deviae from privae consumer prices by a sochasic shock p C PG G = U p. Governmen invesmen is considered o be predominanly infrasrucure invesmen and is herefore priced a he consrucion price index. U The ransfer sysem consiss of wo pars, he benefi BEN = b w paid o he unemployed members of he labour force ( PENS YOUNG NPART L) and oher ransfers TR, including ransfers o pensioners ( PENS ). Unemploymen benefis and pensions are indexed o wages wih replacemen raes U R U U BU b and b, wih b = b + u and b R R BR = b + u. Transfers may also reac o he deb-o-gdp raio and he governmen defici: R G G (72) TR b wpens TRB B ar TRDEF B ar TR = τ ( by ) τ ( def ) + u PTOT PTOT U U Y Y The sock of public capial, which eners he producion funcion (), evolves according o: G G (73) KG = I + ( δ ) KG. G Governmen revenue REV consiss of axes on consumpion, labour and corporae income: G C C C H H W K K I (74) REV = p C + p I + ( ssc + ) wl + ( Y - wl -δ p K) + TAX C C c PTOT TAX wih = + u and TAX = U U. Labour income axes follow a linear scheme, whereas labour income axes are progressive: w w w w w w (75) = τ ( + τ ( y + y + y 2 + y 3 4 y)) = τ Y τ w w wih τ as he average ax rae and τ as he degree of progressiviy. G The dynamics of governmen deb ( B ) is given by: B G ( g ) G G G Con G = + r B + p C + p I + BEN( PENS YOUNG NPART L) + TR (76) G REV g The ineres rae r is he implici ineres rae ha he governmen pays on is deb. I depends on he g b average mauriy srucure of sovereign deb ( / ( ρ ) ) and he rae r on newly issued deb: g g g g b rpremb (77) r = ρ r + ( ρ ) r + u EA EA EA Moneary policy is modeled by a Taylor rule where he ECB ses he policy rae i r + Eπ + in response o area-wide inflaion and real GDP growh. The policy rae adjuss sluggishly o deviaions of inflaion and GDP growh from heir respecive arge levels; he policy rule is also subjec o random shocks: 3 EA T 3 EA EA M, EA EA M, EA T M, EA π i π M, EA y i y i, EA (78) i = τlag i + ( τlag )( r + π + τπ + τ y ) + u 4 4 i= i= 52

55 For he pre-emu period we assume ha moneary policy in he 'Euro Area' was conduced by he Bundesbank, which was seing he German policy rae, however, already argeing Euro aggregaes. A.5. Equilibrium Equilibrium in he domesic model economy is an allocaion by he price sysem and by governmen policies such ha Ricardian and credi-consrained households maximize uiliy, final goods producing firms, firms in he consrucion secor and invesmen goods producers maximize profis and markes clear. The marke clearing for final domesic goods corresponds o (67): C I Con Con G G G X, DE DE M, DE DE (79) Y = pc + pi + p ( I + I ) + pc + p X p M where oal privae consumpion C of domesic and impored goods is he sum of Ricardian and credi-consrained consumpion as heir per-capia consumpion muliplied by he respecive r r populaion shares s and s : r r r c (8) C = sc + ( s) C. Similarly, oal housing and consrucion invesmen are defined as: H r Hr, r Hc, (8) I = si + ( s) I Con r Con, r r Con, c (82) I = si + ( s) I and equilibrium in he labour marke is given by: r r r c r c (83) L = sl + ( s) L wih L = L. Credi-consrained households engage in deb conracs only wih Ricardian households, i.e.: r c r r (84) ( s) B = sb. Toal deposis are he populaion-weighed sum of Ricardian and credi-consrained deposis: (85) D= sd r r + ( s r ) D c. A.6. REA and RoW blocks Res of he euro area (REA) and res of world (RoW) variables are denoed by superscrips RE and RW respecively. In order o idenify demand and supply shocks in he REA and he RoW we use highly aggregaed DSGE models wih aggregae demand modelled by aggregae IS curves ha do no disinguish beween privae and governmen demand: (86) (87) β β RE σ d, RE C, RE d, RE β, RE r Y h Y U E Y d, RE C, RE d, RE = RE + h Y + r RW σ d, RW C, RW d, RW β, RW r Y h Y U E Y d, RW C, RW d, RW = RW + h Y + r Firms' price seing is capured by a hybrid New Keynesian Phillips curve in which inflaion rises in response o he region's oupu gap as he deviaion of acual oupu from an exogenous sochasic rend: (88) (89) π = π + π + ϕ RE RE RE RE RE RE RE T, RE P, RE ( sfp E ( ) ) (ln ln ) RE + sfp Y Y + u + r π ( sfp E π ( sfp ) π ) ϕ (lny ln Y ) u RW RW RW RW RW RW RW T, RW P, RW = RW r where rend oupu follows: (9) lny = ln Y ρ (lny ln Y ) + u (9) lny = ln Y ρ (lny ln Y ) + u T, RE T, RE Y, RE RE DE TFP, RE T, RW T, RW Y, RW RW DE TFP, RW 53

56 GDP in he REA and he RoW equals domesic demand plus he rade balance: RE C, RE d, RE X, RE RE M, RE RE (92) Y = p Y + p X p M RW C, RW d, RW X, RW RW M, RW RW (93) Y = p Y + p X p M The regions' consumer prices relaive o he GDP price deflaor are: (94) RE RE C, RE d, RE M, RE M, RE σm d, RE M, RE /( σm ) = (( + )( ) + ( )) p s u p s u RW RW C, RW d, RW M, RW M, RW σm d, RW M, RW /( σm ) (95) p = (( s + u )( p ) + ( s u )) The REA NIIP posiion follows: RW RW ep, ep,, (96) B = ( + r ) RE B RE + TB + TA + u Y p p where RE p and F RE RW F RE RE RE BW RE RE RW p are REA and RoW GDP process relaive o he German GDP deflaor. Marke DE RE RE RW RW FDE, FRE, FRW, clearing requires TB + p TB = ep TB and B + B = B. Ineres raes in he REA are deermined by (78) ogeher wih (38). RoW ineres raes follow from he Taylor rule: 3 RW T 3 RW RW M, RW RW M, RW T M, RW π i π M, RW y i y i, RW (97) i = τlag i + ( τlag )( r + π + τπ + τ y ) + u 4 4 i= i= RW RW E RW wih he RoW nominal and real raes linked by r = i π +. 54

57 B. Daa descripion Daa on GDP and is componens, governmen finances, ineres raes and exernal accouns for DE and he REA are from Eurosa (Quarerly Naional Accouns, Governmen Finance Saisics, and Balance of Paymen Saisics). The daa on DE house prices come from he ECB Saisical Warehouse. Quarerly daa are seasonally adjused. See Table B. for he lis of variables observed in he esimaion. The daa are no de-rended, only divided by he German populaion rend. The consrucion of oupu, price, rade balance and ineres rae series for he RoW and REA deserves more deail, which is provided below. B.. RoW GDP volume and GDP deflaor The daa for RoW variables are consruced on he basis of daa from 24 non-ea counries. The 24 counries are: Ausralia, Brazil, Bulgaria, Canada, China, Czech Republic, Denmark, Hong Kong, Hungary, Japan, Korea, Lavia, Lihuania, Mexico, New Zealand, Norway, Poland, Romania, Russia, Sweden, Swizerland, Turkey, Unied Kingdom and Unied Saes. The daa for GDP a curren marke prices and GDP a consan prices are aken from AMECO (Ausralia, Brazil, Canada, China, Hong Kong, Korea, Mexico, New Zealand and Russia) and Eurosa Quarerly Naional Accouns (all oher counries) daabases. The AMECO daa are annual daa ha have been convered ino quarerly frequency. RoW (RW) nominal GDP is calculaed as sum of nominal GDP for he 24 counries, wih nominal values convered ino USD wih E as he exchange rae of USD o naional currency: RW 24 i i YN = E i YN = Given he currency ransformaion ino USD, price inflaion in he RoW is defined in USD erms and includes REER movemens beween he RoW members. The use of USD prices is consisen wih using he Euro-USD exchange rae in rade equaions of he model and US ineres raes in he RoW moneary policy rule. RoW nominal GDP is hen normalised by is value in he base year = (25), giving he index: RW RW RW YNk YN = YN ( ) k = RW YNk To derive real GDP in he RoW, we firs consruc series for he 24 counries of GDP a consan domesic prices and normalise he series wih GDP in he base year = (25): i i i YRk YR = YN ( ) k = i YRk RoW real GDP is hen calculaed as he GDP-weighed mean of he 24 counry series: i i RW 24 E YN i YR = i = YR RW YN The aggregaion applies ime-varying weighs in paricular o accoun for he gain in relaive economic weigh of emerging economies over he sample period. Applying consan weighs gives very similar aggregae real GDP dynamics in our case, however. RoW inflaion is he percenage change in he price level in USD erms given by he raio: RW RW YN P = RW YR The RoW price level series measures he gap beween RoW nominal GDP in USD erms and RoW real GDP as he weighed average of GDP in consan naional prices. I herefore includes 55

58 flucuaions in he nominal exchange rae beween he USD and he currencies of oher counries in he RoW sample. Consequenly, aggregae RoW prices can be expeced o be less sicky a shorer frequencies han prices in one currency a he naional level. B.2. REA GDP volume and GDP deflaor Daa for oupu and prices in he REA (RE) are derived on he basis of nominal and real GDP daa for DE and he euro area (EA) aggregae, where nominal GDP is oupu a curren euro prices and real GDP is oupu a consan euro prices. RoEA nominal GDP is he difference beween euro-based EA and DE nominal GDP: RE, EA, DE, YN = YN YN The relaive GDP weighs allow calculaing RoEA inflaion based on EA and DE nominal and real GDP daa: EA DE, DE P YN P RE EA EA, DE P P YN P = RE DE, P YN EA, YN The RoEA price level relaive o he base year = and RoEA real GDP in prices of = are: RE RE RE Pk P = P ( ) k = RE Pk RE RE, RE YR = YN / P B.3. REA and RoW rade balance DE Eurosa Quarerly Naional Accouns repor nominal rade balances for Germany ( TB ) and he EA oal EA ( TB ) in EUR erms. Given he regional configuraion of he model, he RoW and RoEA values can be derived simply: RW EA TB = TB RE DE RW TB = ( TB + TB ) B.4. Ineres raes As RoW prices are expressed in USD erms, he exchange rae beween he EA and he RoW is he EUR/USD rae. The RoW nominal ineres rae used in he RoW moneary policy rule and he ineres pariy condiion deermining he EUR/USD exchange rae is he 3-monh money marke ineres rae in he Unied Saes. Nominal ineres raes for he DE and RoEA blocks are as follows. The nominal ineres rae of DE corresponds o he 3-monh money marke rae for Germany prior o 999. The RoEA nominal rae is calculaed from he German rae and he synheically EA rae: DE, EA YN DE i i EA, RE YN i =, DE, YN EA, YN During 999q-24q2, he DE and RoEA nominal raes correspond o he 3-monh money marke ineres rae for he EA. From 24q3 on, DE INOM corresponds o he AAA governmen bond yields in he EA for 3-monh mauriy as published by he ECB. The corresponding RoEA rae hen follows from he average EA 3-monh bond yield for all raings and he 3-monh AAA rae as above. 56

59 The use of governmen bond raes insead of ECB policy raes for mos recen periods akes ino accoun he spreads beween DE and RoEA financing coss in recen years. The ECB series for EA governmen bond yields sar only in 24q3, which is he reason for using ECB money marke raes up o 24q2. Comparing DE governmen bond yields wih ECB policy raes shows ha governmen bond yields have moved closely wih money marke raes during Table B.: DE Real GDP Privae consumpion o GDP Governmen purchases o GDP Governmen invesmen o GDP Observed variables in he esimaion Employmen Wage share Labour force paricipaion rae Old-age populaion share Young-age populaion share Invesmen o GDP Consrucion invesmen o GDP Impors o GDP GDP deflaor Privae consumpion deflaor Governmen consumpion deflaor Invesmen price deflaor Consrucion price deflaor House price deflaor Impor price deflaor Expor price deflaor Transfers o GDP Benefis o GDP Benefi replacemen rae VAT rae Governmen deb o GDP Governmen balance o GDP Effecive ineres on governmen deb Nominal ineres rae Nominal exchange rae Curren accoun o GDP Transfer accoun o GDP NFA o GDP Share in euro-area GDP REA Real GDP GDP deflaor REA nominal ineres rae Trade balance o GDP Transfer accoun o GDP NFA o GDP Euro-area nominal ineres rae RoW Real GDP GDP deflaor Nominal ineres rae 57

60 C. Economeric mehodology and parameer esimaes We calibrae selecs parameers. The remaining parameers are esimaed using Bayesian mehods. C.. Calibraed parameers We calibrae he seady sae raion of German deb/annual GDP a 6, which is close o he sample average. This implies a seady sae defici of.8 of GDP. The average mauriy of German governmen deb is se a 5 years. Tax and replacemen raes are calibraed on sample averages. Based on he sample average, he seady sae quarerly growh rae of German nominal GDP is se.27, and he seady sae inflaion rae is se a.5 per quarer. Collaeral-consrained households have a seady sae rae of ime preference of 4, while he seady sae rae of ime preference of non-consrained households is esimaed. The seady sae raios of main economic aggregaes (corporae invesmen, consrucion invesmen, governmen consumpion and governmen invesmen) o GDP are calibraed o sample averages. C.2. Parameer esimaes The model is esimaed on quarerly daa for he period 995q o 23q2 using Bayesian inference mehods o esimae model parameers and shocks. We use he DYNARE oolbox for MATLAB (Adjemian e al., 2) o conduc he firs-order approximaion of he model, calibrae he seady sae and perform he esimaion. The following Tables repor he priors of all esimaed model parameers as well as he corresponding poserior modes and sandard deviaions. 58

61 Table C.: Calibraed parameers and seady-sae raios Parameers and seady-sae raios Symbol Value Parameers Symbol Value w DE Progressive labour ax componen τ.8 Governmen deb arge by ar.6 Persisence of governmen consumpion.99 Loan-o-value raio χ c IG.5 Persisence of governmen invesmen.99 Capaciy-uilisaion adjusmen coss γ ucap,.79 Reiree populaion share RETIR.82 Labour share in producion α.67 Young-age populaion share YOUNG.45 Public capial in producion -α G. Non-paricipaion share NPART.85 TFP scaling facor A.852 Persisence RETIR shock ρ RETIR.975 Capial depreciaion rae δ K.25 Persisence YOUNG shock ρ YOUNG.975 Housing depreciaion rae δ H. Persisence NPART shock ρ NPART.99 Public capial depreciaion rae δ G.3 Rae of ime preference credi-consrained HH -/ β c.4 Capial requiremen -s d. Rae of ime preference Ricardian HH -/β r.5 Elasiciy of deposi rae o deposi raio κ d. Subsiuabiliy beween goods varieies η 2. Persisence in capaciy uilizaion ρ ucap.99 Subsiuabiliy beween labour varieies θ 6. Ineria in credi consrain ρ d,c.9 Growh rae of land sock g L.8 CC s H Housing in final demand by credi-consrained HH.7 REA share in DE impors s DE,RE.397 NLC s H Housing in final demand by Ricardian HH 2.89 RoW share in DE impors s DE,RW.63 Consumpion-housing subsiuabiliy σ H.5 Persisence C G price shock ρ PG.946 Forward-looking in house price expecaions sfp h. Persisence CPI shock ρ PC.99 Land value val L.5 Persisence governmen borrowing coss ρ g.95 Uiliy weigh of leisure ϑ.72 DE share in EA oupu s de.287 Risk premium on physical capial rprem k.36 REA Risk premium on land rprem l. Goods marke home bias s d,re.794 Risk premium on governmen bonds rprem b.4 DE share in REA impors s RE,DE.269 Counry risk premium rprem e. RoW share in REA impors s RE,RW.73 Premium on deposis rprem d.3 Rae of ime preference of households -/β RE.5 Sensiiviy of deposi rae w.r.. o deposis (r) ω d,r.2 Persisence of impor price shock ρ PM,RE.9 Sensiiviy of deposi rae w.r.. o deposis (c) ω d,c.3 Persisence of risk premium shock ρ rpremre.97 Seady-sae G/Y share C G /Y.93 Long-run convergence ρ Y,R E.4 Seady-sae IG/Y share I G /Y.9 RoW Producive invesmen share in GDP I/Y.27 Goods marke home bias s d,rw.973 Toal invesmen share in GDP (I+I Con +I G )/Y.29 DE share in RoW impors s RW,DE.335 Corporae ax rae k.2 RoW share in RoW impors s RW,RE.665 VAT rae c.9 Rae of ime preference of households -/β R.5 Social securiy conribuion rae ssc.7 Persisence of impor price shock ρ PM,RW.9 Linear labour ax componen w τ.2 Long-run convergence ρ Y,R W.4 CG τ Lag τ Lag 59

62 Table C.2: Parameers Esimaion resuls for srucural parameers DE disrib mean sd mode sd Housing sock adjusmen coss γ H Gamma Housing invesmen adjusmen coss γ Ih Gamma Capial sock adjusmen coss γ K Gamma Invesmen adjusmen coss γ I Gamma Impor demand sickiness γ M Gamma Employmen adjusmen coss γ L Gamma Price adjusmen coss γ P Gamma Consrucion price adjusmen coss γ Con Gamma Impor price adjusmen coss γ Pm Gamma Expor price adjusmen coss γ Px Gamma Wage adjusmen coss γ W Gamma Quadraic capaciy-uilisaion adjusmen coss γ ucap,2 Gamma Real wage ineria ρ w Bea Consumpion habi persisence h c Bea Inverse of labour supply elasiciy κ Gamma Goods marke home bias s d Bea Forward-looking in goods price expecaions sfp Bea Forward-looking in consrucion price expecaions sfp Con Bea Forward-looking in impor price expecaions sfp m Bea Forward-looking in expor price expecaions sfp x Bea Forward-looking in wage expecaions sfw Bea Ricardian household share s r Bea Inverse of ineremporal elasiciy of subsiuion σ Gamma DE Price elasiciy of impors Gamma DE Price elasiciy of impors of differen sources σ Gamma Price elasiciy of land demand σ L Bea Land share in producion of housing services s L Bea Response of governmen purchases o deb τ B Bea Response of governmen purchases o defici τ DEF Bea Response of ransfers o deb τ TRB Bea Response of ransfers o defici τ TRDEF Bea Sensiiviy of bond risk premium o public deb ω b Bea REA Impor demand sickiness Bea Consumpion habi persisence h C,RE Bea Forward-looking in goods price expecaions sfp RE Bea RE Price elasiciy of impors Gamma RE Price elasiciy of impors of differen sources σ Gamma Inverse of ineremporal elasiciy of subsiuion σ RE Gamma Slope of Phillips curve ϕ RE Gamma Moneary policy response o inflaion M, EA Bea Moneary policy response o oupu M, EA Bea Moneary policy rae persisence Bea RoW σ M RE γ m σ M τ π τ y M, EA τ lag RW γ m Impor demand sickiness Bea Consumpion habi persisence h C,RW Bea Forward-looking in goods price expecaions sfp RW Bea σ M RW Price elasiciy of impors Gamma Price elasiciy of impors of differen sources Gamma Inverse of ineremporal elasiciy of subsiuion σ RW Gamma Slope of Phillips curve ϕ RW Gamma M, RW τ π Moneary policy response o inflaion Bea τ y Moneary policy response o oupu M, RW Bea M, RW τ lag Moneary policy rae persisence Bea Prior Poserior

63 Table C.3: Esimaion resuls for exogenous shocks Shocks DE disrib Prior mean sd mode Poserior sd Shock o ime preference rae σ β Gamma Shock o goods price mark-up σ ε Gamma Shock o consrucion price mark-up σ pcon Gamma Shock o impor price mark-up σ PM Gamma Shock expor price mark-up σ PX Gamma Shock o governmen purchases σ CG Gamma Shock o governmen invesmen σ IG Gamma Shock o labour supply σ L Gamma Shock o impor demand σ M Gamma Shock o consumer prices σ PC Gamma Shock o counry risk premium σ rpremde Gamma Shock o invesmen risk premium σ rpremk Gamma Shock o housing risk premium σ rpremh Gamma Shock o labour demand σ W Gamma Shock o TFP σ Y Gamma Shock o ransfers σ TR Gamma Shock o land sock σ gl Gamma Persisence ime preference shock ρ β Bea Persisence goods mark-up shock ρ ε Bea Persisence consrucion mark-up shock ρ pcon Bea Persisence impor mark-up shock ρ PM Bea Persisence expor mark-up shock ρ PX Bea Persisence impor shock ρ M Bea Persisence counry risk shock ρ rpremde Bea Persisence invesmen risk shock ρ rpremk Bea Persisence housing risk shock ρ rpremh Bea Persisence labour demand shock ρ W Bea Persisence ransfer shock ρ TR Bea Persisence land sock shock ρ gl Bea REA Shock o price mark-up σ ε,re Gamma Shock o impor demand σ M,RE Gamma Shock o moneary policy σ i,ea Gamma Shock o euro/dollar risk premium σ rpremea Gamma Shock o counry risk premium σ rpremre Gamma Shock o ime preference rae σ β,re Gamma Shock o TFP σ TFP,RE Gamma Persisence impor demand shock ρ M,RE Bea Persisence euro area risk premium ρ rpremea Bea Persisence ime preference shock ρ β,re Bea Persisence TFP shock ρ TFP,RE Bea RoW Shock o price mark-up σ P,RW Gamma Shock o impor demand σ M,RW Gamma Shock o moneary policy σ i,rw Gamma Shock o ime preference rae σ β,rw Gamma Shock o TFP σ TFP,RW Gamma Persisence price shock ρ ε,rw Bea Persisence ime preference shock ρ β,rw Bea

64 Table C.4: Calibraed exogenous shocks Shocks Symbol Value DE Shock o unemploymen benefi replacemen rae σ BU.5 Shock o pension benefi replacemen rae σ BR.5 Shock o RETIR shock σ RETIR.2 Shock o YOUNG σ YOUNG.2 Shock o NPART σ NPART.2 Shock o C G price σ PG.6 Shock o governmen financing coss σ rpremb. Shock o consumpion ax rae σ c.2 Shock o lump-sum axes σ TAX.5 Shock o ransfer accoun σ TA,DE. Shock o NFA value σ BWREV,DE.5 NFA residual σ BW,DE.25 REA Shock o ransfer accoun σ TA,RE.5 Shock o NFA value σ BW,RE.4 62

65 Table C.5: Model-prediced and empirical business cycle saisics (firs-differenced variables) Model Daa Sandard Correl. wih Sandard Correl. wih deviaion, German GDP deviaion, German GDP () (2) (3) (4) German variables GDP Consumpion (privae) Invesmen Producion capial Governmen capial Consrucion Governmen consumpion Hours worked Expors Impors Ineres rae Inflaion rae, GDP deflaor Inflaion rae, expor price Inflaion rae, impor price Exchange rae, depreciaion rae Ne expors/gdp Curren accoun/gdp Saving rae Invesmen rae REA variables GDP Inflaion ROW variables GDP Inflaion Noe: he Table repors model-prediced sandard deviaions and correlaions wih German GDP (Columns ()- (2)) and he corresponding empirical saisics based on quarerly daa for he period 995q-23q2 (Columns (3)-(4)). All saisics perain o firs-differenced variables. Saisics for GDP, privae and governmen consumpion, invesmen, hours, expors and impors (in real erms) perain o firs differences of logged variables. The saving rae (invesmen rae) is he raio of nominal naional gross savings (invesmen) o nominal GDP. The raios of ne expors and of he curren accoun o GDP are raios of nominal variables. The empirical nominal exchange rae is he Euro-USD exchange rae. REA: Res of Euro Area (EA less Germany). ROW: Res of World. 63

66 D. Sensiiviy analysis Sensiiviy analysis w.r.. seady sae (long-run) assumpions abou German ne foreign asses (NFA) Table D.: CA shock decomposiion assuming seady sae NFA equals 4 of annual GDP 64

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