Structural fiscal balances of the UK: a state-space DSGE approach

This article proposes a new framework to estimate and analyse structural fiscal balances of the UK, by combining the state-space modelling with the Bayesian DSGE modelling. In this way, trends and cycles of aggregate variables can be extracted from data consistently with the macroeconomic theory. A setting of an integrated random walk for the underlying stochastic trends fits the data best. An expansion in government spending can increase nominal fiscal revenue to a certain degree, but the effect is not persistent due to two kinds of crowd-out effects: it crowds out domestic investment; and it pushes up the price of domestic goods and simultaneously crowds out the foreign demand. The shocks to the nominal interest rate, foreign output and the government spending are the three major contributors to the variation of the fiscal revenue cycle.     

Flexible policies and IS-LM dynamics

A dynamic IS-LM model with a Phillips curve is used to analyze the consequences of familiar flexible government policies. The dynamic behavior of the model depends critically upon the monetary and fiscal policies followed by the government. If a passive stance is taken in which real government spending and the nominal money supply do not adapt to the course of economic events, then the model is unstable. The government can, however, follow simple policy rules which stabilize the economy. The most clearly stable policies involve the joint employment of monetary and fiscal policies.     

Optimal fiscal and monetary policy with sticky wages and sticky prices

We determine the optimal degree of price inflation volatility when nominal wages are sticky and the government uses state-contingent inflation to finance government spending. We address this question in a well-understood Ramsey model of fiscal and monetary policy, in which the benevolent planner has access to labor income taxes, nominally risk-free debt, and money creation. Our main result is that sticky wages alone make price stability optimal in the face of shocks to the government budget, to a degree quantitatively similar as sticky prices alone. Key for our results is an equilibrium restriction between nominal price inflation and nominal wage inflation that holds trivially in a Ramsey model featuring only sticky prices. Our results thus show that when nominal wages are sticky, setting real wages as close as possible to their efficient path is a more important goal of optimal monetary policy than is financing innovations in the government budget via state-contingent inflation. A second important result is that the nominal interest rate can be used to indirectly tax the rents of monopolistic labor suppliers. Taken together, our results uncover features of Ramsey fiscal and monetary policy in the presence of a type of labor market imperfection that is widely-believed to be important.     

Perpetual youth and endogenous labor supply: A problem and a possible solution

In the “perpetual youth” overlapping-generations model of Blanchard and Yaari, if leisure is a “normal” good then some agents will have negative labor supply. We suggest a solution to this problem by using a modified version of Greenwood, Hercowitz and Huffman’s utility function. The modification incorporates real money balances, so that the model may be used to analyze monetary as well as fiscal policy. In a Walrasian version of the economy, we show that increased government debt and increased government spending raise the interest rate and lower output, while an open-market operation to increase the money supply lowers the interest rate and raises output.     

The importance of composition of fiscal policy: evidence from different exchange rate regimes

We study the macroeconomic effects of fiscal policies in an open economy. We emphasize two transmission mechanisms: the cost channel, by which wage government spending and labor taxes raise the real wage firms must pay, and the exchange rate channel, by which the nominal exchange rate shifts induced by fiscal policy have real effects if (some) prices and wages are sticky. The latter channel implies that changes in wage government spending or in labor taxation should have different effects under flexible than under fixed exchange rates. In a 1964–93 panel of OECD countries we find significant evidence for both channels. Moreover, we find that the real product wage and profitability are more responsive than quantities (employment and output) to fiscal policy innovations.     

Monetary–fiscal policy interactions and fiscal stimulus

Increases in government spending trigger substitution effects—both inter- and intra-temporal—and a wealth effect. The ultimate impacts on the economy hinge on current and expected monetary and fiscal policy behavior. Studies that impose active monetary policy and passive fiscal policy typically find that government consumption crowds out private consumption: higher future taxes create a strong negative wealth effect, while the active monetary response increases the real interest rate. This paper estimates Markov-switching policy rules for the United States and finds that monetary and fiscal policies fluctuate between active and passive behavior. When the estimated joint policy process is imposed on a conventional new Keynesian model, government spending generates positive consumption multipliers in some policy regimes and in simulated data in which all policy regimes are realized. The paper reports the model's predictions of the macroeconomic impacts of the American Recovery and Reinvestment Act's implied path for government spending under alternative monetary–fiscal policy combinations.     

THE PRICE LEVEL, THE QUANTITY THEORY OF MONEY, AND THE FISCAL THEORY OF THE PRICE LEVEL

This paper examines price‐level determination from the perspective of portfolio choice. Arbitrages among money balances, bonds, and investment goods determine their relative demands. Returns to real balance holdings and after‐tax returns to investment goods determine the relative values of nominal and real assets. Because expectations of government policies ultimately determine the expected returns to both nominal and real assets, the price level depends on interactions among current and expected future monetary and fiscal policies. The quantity theory and the fiscal theory emerge as special cases produced by restricting both the margins and the policies considered.     

Identifying fiscal policy (in)effectiveness from the differential counter‐cyclicality of government spending in the interwar period

Differences across decades in the counter‐cyclical stance of fiscal policy can identify whether the growth in government spending affects output growth and so speeds recovery from a recession. We study government‐spending reaction functions from the 1920s and 1930s for twenty countries. There are two main findings. First, surprisingly, government spending was less counter‐cyclical in the 1930s than in the 1920s. Second, the growth of government spending did not have a significant effect on output growth, so that there is little evidence that this feature of fiscal policy played a stabilizing role in the interwar period.     

Tax Base and Crowding‐in Effects of Balanced Budget Fiscal Policy

A dynamic general equilibrium business cycle model is constructed with staggered price adjustment, monopolistic wage setting and distortionary taxation. The government purchases goods, runs an unemployment benefit system and balances its budget through a proportional tax on labour income. A temporary tax‐financed increase in government expenditures can lower the tax rate through a demand‐induced widening of the tax base. It is shown analytically that this allows private consumption to rise, under realistic conditions, despite the negative wealth effect of increased fiscal spending.     

Effectiveness of Fiscal Policy in a Model of Imperfect Competition With Transactions Money

This paper examines the effectiveness of fiscal policy in a general equilibrium macromodel with transactions money and an oligopolistic product market. The results suggest that although money may be neutral and play no direct role as a policy instrument, its indirect impact on the effectiveness of fiscal policy can be quite substantial. In particular, when money balances feature as a choice variable in the households' objective function, (i) fiscal policy becomes ineffective as the weight attached to money is reduced; (ii) the fiscal multiplier becomes negative when the elasticity of substitution between money and leisure exceeds unity; and (iii) it is possible that policy effects are in fact enhanced as the product market becomes more competitive.     

The Crisis of America’s Cities

This paper aims to show how state intervention within the European Monetary Union can have positive effects not only on growth but also on public balances and debt. The relation between centralized monetary policy and decentralized fiscal policy partly solves the lack of coordination between the two. Each time a fiscal expansion in an EU country is not accompanied by a Central Bank interest rate increase, the expansionary effect of public spending, initially financed through the emission of public bonds, will be reinforced by endogenous money creation due to the increase in growth. The final result, if growth exceeds the rate of interest, is not only an increase in equilibrium income, but also a reduction in debt.     

RE-EXAMINING THE EFFECTIVENESS OF STABILISATION POLICY

This paper develops an alternative international macroeconomic model for evaluating the effectiveness of fiscal and monetary policy in stabilising national income under fixed and floating exchange rates. It encompasses national output and income, saving, investment, money and capital flows and linkages between the exchange rate, price levels and real interest rates consistent with international parity conditions. It demonstrates that the nature of government spending is pivotal to the effectiveness of fiscal policy, revealing that, ceteris paribus , higher public consumption expenditure contracts national income and depreciates the exchange rate, whereas higher productive public investment spending has opposite effects. The framework also shows that the effectiveness of fiscal and monetary policy as macroeconomic policy instruments is not ultimately dependent on the exchange rate regime.     

Inside and outside fiat money, gains to trade, and IS-LM

Summary. We build a one-period general equilibrium model with money. Equilibrium exists, and fiat money has positive value, as long as the ratio of outside money to inside money is less than the gains to trade available at autarky. We show that the nominal effects of government fiscal and monetary policy can be completely described by a diagram identical in form to the IS-LM curves introduced by Hicks to describe Keynes' general theory. IS-LM analysis is thus not incompatible with full market clearing, multiple commodities, and heterogeneous households. We show that as the government deficit approaches a finite threshold, hyperinflation sets in (prices converge to infinity and real trade collapses). At the other extreme, if the government surplus is too large, the economy enters a liquidity trap in which nominal GNP sinks and monetary policy is ineffectual. Received: January 2, 2002; revised version: April 8, 2002 Correspondence to: P. Dubey     

FISCAL POLICY AND AGGREGATE CONSUMPTION: NEW EVIDENCE FROM THE UNITED STATES

In this paper we estimate the marginal rate of substitution between aggregate per-capita consumption and per-capita government expenditure on goods and services using US quarterly data over the period 1953 to 1993. This estimate is an important input to any attempt to assess the overall effectiveness of fiscal policy since it directly affects the size of the fiscal policy multiplier. Other recent consumption studies which incorporate the effects of government expenditure have failed to establish a stable estimate of the marginal rate of substitution. We argue that this failure results from imposing the unrealistic assumption that this parameter is constant. In contrast, we allow the marginal rate of substitution to depend on both the level and composition of government spending.     

On Income Velocity of Money,Precautionary Money Demand and Growth

A stochastic growth model with money introduced via a cash-in-advance constraint is used to analyze the behavior of the income velocity of real monetary balances and money demand. Agents can purchase consumption goods only using government issued money. The cash-in-advance constraint may become nonbinding because of the uncertainty about the realization of the state of the economy. We find that the precautionary money demand may introduce significant changes into the volatility of the income velocity if it happens almost always. Its presence can also alter the relationship between the average growth rate of money supply and the average growth rate of the economy.     

“CONVENTIONAL” MONETARY POLICY IN OLG MODELS: REVISITING THE ASSET-SUBSTITUTION CHANNEL

Conventional monetary policy involves actions by the monetary and fiscal authorities: the former sets a nominal interest rate and the latter sets lump-sum taxes to finance the implied flow of interest payments on government debt. We model such policy within an overlapping generations framework and show that absent any other frictions the magnitude of the nominal interest rate gives rise to asset substitution between government debt and either private debt or capital—substitution that has both real and nominal effects. Such substitution is not in standard New Keynesian models because their dynastic specification implies that government debt is not net wealth.     

The Effects of Macroeconomic Policy with a Disparity in Price Elasticity Between Private‐ and Public‐ Sector Demands

We introduce a disparity in price elasticity between government demand and consumption demand into a simple money‐in‐the‐utility‐function model. This extension demonstrates that the effect of fiscal policies on production may be positive, negative, or neutral depending on the disparity in price elasticity between sectors. Because the effect of an increase in nominal money supply with constant nominal government expenditure is the opposite to that of a fiscal policy, a fiscal policy financed by seigniorage can have positive, negative, or no effects depending on parameter values. Moreover, the effect of simultaneous implementation of expansionary–contractionary policies depends on how they are combined.     

Financing government investment and its implications for public capital: A small open economy perspective

Expenditure reductions played a key role in many small open economies during fiscal consolidation, with large declines in public investment. This led to a reduction in public capital stock and affected the competitiveness of these economies. After the sovereign debt crisis, the governments that consider increasing investment to replenish the public capital stock have limited fiscal space and have to avoid external imbalances. We show that using budget-neutral investment spending can generate long-term benefits of higher public capital stock while at the same time limiting negative consequences for the public finances and the trade balance. The best way of financing government investment, which preserves fiscal and trade balances, and increases welfare, is by reducing other government spending. The second-best is financing investment with value-added tax. Financing with debt worsens fiscal and trade balances, while using distortionary labour taxes reduces labour supply, increases wage costs and worsens the trade deficit in the short run.     

How does population aging affect the effectiveness of fiscal stimulus over the business cycle?

What is the impact of population aging on the effectiveness of fiscal stimulus over the business cycle? We address this question by estimating state-dependent fiscal multipliers in member countries of the Organisation for Economic Co-operation and Development (OECD). A government spending shock is identified as a forecast error of government spending and its output effect is estimated by using the local projection method. We find that there is no effect of population aging on output effects of fiscal spending shocks in expansionary times, whereas in recessions the output effects of fiscal spending shocks are weakened as population ages. This result points to important policy implications in that population aging would call for a larger fiscal stimulus to support aggregate demand during recession. Thus, this requires a larger fiscal space to allow for a wider swing of the fiscal position without creating concerns for fiscal sustainability.     

A Fiscal Stimulus and Jobless Recovery

We analyze the effects of a government‐spending expansion in a dynamic stochastic general equilibrium model with Mortensen–Pissarides labor‐market frictions, deep habits in private and public consumption, investment adjustment costs, a constant elasticity of substitution (CES) production function, and adjustments in employment at both intensive and extensive margins. The combination of deep habits and CES technology is crucial. The presence of deep habits magnifies the responses of macroeconomic variables to a fiscal stimulus, while an elasticity of substitution between capital and labor in the range of available estimates allows the model to produce a scenario compatible with the observed jobless recovery.