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stabilisation in EMU
Campbell Leith and Simon Wren-Lewis
The potential importance of fiscal policy in influencing inflation has
recently been highlighted, followingWoodford (1998); under the heading of
the Fiscal Theory of the Price Level (FTPL). The Fiscal Theory has also been
extended to consider the case of independent fiscal authorities operating
under a common monetary authority (seeWoodford 1998; Dupor 2000;
Bergin 2000; Sims 1997).
The fiscal theory essentially characterises two regimes one where the
fiscal authorities act prudently, government debt does not constitute an
element of net wealth and monetary policy is free to target inflation, and
another, where fiscal insolvency requires surprise inflation to deflate the
nominal value of government debt. In Leith and Wren-Lewis (2001) we relax
a number of assumptions underlying the Fiscal Theory of the price level by
considering a two-country model in continuous time with overlapping
generations of consumers supplying labour to imperfectly competitive firms
which can only adjust their prices infrequently. Policy is described by simple
linear feedback rules. We find that there are two stable policy regimes similar
to those in the Fiscal Theory: one where the government follows a rule which
stabilises its debt and monetary policy is active in the sense of Leeper
(1991) and another where an imprudent government requires monetary
policy to be passive. However, unlike the Fiscal Theory, both monetary and
fiscal policy affect inflation in both regimes.We also obtain the result that it is
theoretically possible for one fiscal authority to partially compensate for
some degree of lax fiscal policy on the part of another monetary union
member, without implying an indefinite transfer of wealth from the citizens
of that economy to the other.
In this chapter we extend this work by developing a two-country open
economy model in discrete time, where again each country has overlapping
generations of non-Ricardian consumers who supply labour to imperfectly
competitive firms which can only change their prices infrequently.We
examine the case where the two countries have formed a monetary union,
but where the fiscal authorities remain independent. We allow for a richer
menu of monetary and fiscal policy interaction by dropping the assumption
of lump sum taxation and allowing the fiscal authorities to vary both tax
rates (which are distortionary) and government spending (which feeds
directly into aggregate demand). We restrict ourselves to considering only
the policy regime in which the fiscal authorities act to stabilise their own
debt, and where monetary policy is active, as this appears to characterise
EMU under the Stability and Growth Pact. We then examine, through a series
of policy simulations, how asymmetries in the fiscal policy responses to debt
disequilibrium can affect the European Central Banks ability to control
inflation.We assume that each fiscal authority stabilises its own debt
sufficiently to allow an active monetary policy regime, but ask what is the
appropriate speed of debt stabilisation, and whether stabilization that is too
slow or too fast in one country will significantly influence the other.
The structure of the chapter is as follows. Section 1 outlines the model
and section 2 examines the steady state of the model and linearises the nonlinear model around this steady state. Section 3 then calibrates the model,
before assessing the implications of (1) varying the speed of fiscal
adjustment to debt disequilibrium, (2) asymmetric responses in fiscal policy
to disequilibrium in the debt levels of the independent fiscal authorities and
(3) asymmetries in the extent of nominal inertia across EU member states in
the face of various symmetric and asymmetric shocks. Section 4 concludes.
1. The model
Our model consists of two countries operating under a monetary
union, where a single monetary authority targets average consumer price
inflation across the union, but each countrys fiscal authorities are free to
pursue independent fiscal policies. Within each country, overlapping
generations of consumers supply labour to imperfectly competitive firms.
Consumers in each country do not expect to live for ever, and there are no
bequests in the model, so the conditions underpinning pure Ricardian
equivalence do not hold. As a result the governments liabilities (consisting
of money and bonds) constitute an element of net wealth and will,
therefore, affect the real interest rate observed in the model.We also
assume that the imperfectly competitive firms in each economy can only
reset prices at random intervals, as under Calvo (1983) contracting. The
combination of non-Ricardian consumers and nominal inertia implies that
monetary and fiscal policies interact and that both can have real effects on
the economy. We now proceed to outline the model in more detail,
considering first the problem facing individual consumers, before
aggregating across all consumers. We then turn to the pricing/output
decisions of our representative firm before detailing the linearisation of the
model required to render it suitable for numerical simulation.
1.1 The consumers problem
The utility of a typical home consumer, i, is increased through consumption of a
basket of consumption goods, cis , holding real money balances, Mis Ps , and suffers
disutility from providing labour services, Ni s . Consumers also face a constant
probability of death (1 ), which allows us to write the consumers certainty equivalent
utility function as,
Since there are assumed to be no impediments to trade, the law of one price holds
for each individual good, so that the home price index can be rewritten as
where p(z) is the home currency price of good z, p*(z) is the foreign currency
price of good z and is the nominal exchange rate, which is fixed under monetary union.
The consumer can hold her financial wealth in the form of domestic government
bonds, D, foreign bonds, F, and money balances, M. Since there is a common monetary
policy, domestic and foreign bonds earn the same nominal return, it, and domestic
consumers receive a share in the profits of domestic firms. It is assumed that the
consumer receives a premium from perfectly competitive insurance companies in return
for their financial assets should they die. This effectively raises the rate of return from
holding financial assets by 1 . The consumer also receives labour income of Wt Ni t and
a share of the profits from all the imperfectly competitive firms in the economy, t .2 The
consumers labour and profit income is taxed at a rate t . Therefore, the consumers
budget constraint, in nominal terms, is given by
where rt is the ex-ante real interest rate. The parameters and * measure the proportion
of domestic and foreign bonds, respectively, which are nominal. Therefore, when = *
= 0 all financial wealth is fully indexed such that the ex-post real interest rate enjoyed by
holders of the financial asset is equivalent to the ex-ante real interest rate they expected.
When = * = 1 all debt is nominal and surprise inflation can erode the real value of
nominal financial wealth by decreasing the ex-post real interest rate relative to the ex-ante
rate as under the FTPL. In our policy simulations we shall assume that the economy was
initially in steady state before an unanticipated shock moved the economy away from this
steady state. We shall then track the response of the economy to this shock under different
descriptions of monetary and fiscal policy. As a result, when the shock hits the economy
it is possible for ex-ante real rates to differ from ex-post real rates. However, for the
remainder of the simulation, owing to the pooling of risks due to finite lives and
stochastic price setting, the economy behaves as if it is operating under perfect foresight.
Therefore we can drop the distinction between ex-ante and ex-post real rates in periods
other than the initial period, t, in which the shock hits. The consumer then has to
maximise utility, (8.1), subject to her budget constraint, (8.5), along
with the usual solvency conditions. The various first order conditions
this implies are given below.
Firstly, there is the usual consumption Euler equation
The optimisation also yields a money demand equation
1
s
s
. Therefore the total size of the population is =
1 .
s=0
We will also assume that the probability of death and initial
cohort size are identical across the two countries. As a result, by
examining average per capita values of variables we can still
compare aggregate levels of variables across countries.
Therefore the relationship between aggregate per capita labour
supply and consumption in all cohorts3 is given as,
money demand,
and consumption,
1.2
The firms problem
We now turn the problem facing the firm. As consumers are able to
pool the risks associated with asymmetric price setting on the part of
individual firms, the representative firms objective is to maximise the
discounted value of its profits using the risk-free interest rate.
Therefore we define the real profits of the home firm, producing good
z, as
Integrating demands across consumers, noting that PPP holds for the
aggregate consumer price levels and assuming that the home
government allocates its spending in the same pattern as home
consumers implies that world demand for product z is given by,
where y(z), c, c*, g, and g* are defined as real per capita variables. The
firms (per capita) demand for labour will be equivalent to equation
(8.22). Utilising the home and foreign demands for product z allows us
to rewrite the firms objective function as
1.3
The government
Finally, we consider the governments of both economies. The home
governments budget constraint, in nominal terms, is given by
where the interest paid on this debt may or may not be indexed to
inflation.We shall discuss the formulation of both monetary and fiscal
policy below.
1.4
Global market clearing conditions
In our two-country model there are also global market clearing
conditions for the goods and asset markets. In the goods market it
implies the following condition
while equilibrium in the asset market implies that the sum of private
financial assets in the two economies equals the sum of public
liabilities,
In both cases the usual closed economy identities do not hold, as one
economy can be a net exporter to the other and can also hold net
foreign financial assets.
2. Linearising the model around a symmetric steady state
In order to get the model into a tractable form for conducting policy
simulations we need to linearise it (the infinite forward-looking
summations implied by the firms pricing decisions cannot be dealt with in
a non-linear framework, even if we undertake numerical simulations). In
this section we detail the steady state of our model, before log-linearising
the dynamic equations around this steady state.
2.1
The symmetrical steady state of the model
In this section we derive the steady state of our model, as this will be
the base around which we log-linearise our model before conducting a
number of numerical policy simulations. The optimal price in steady
state, which is the same as that which would be set under flexible
prices, is given by
As the firms in the economy lose market power and tend towards
a state of perfect competition. Combining this with the labour supply
condition (8.12), the linear production function and the national
accounting identity in a symmetrical steady-state, y = c + g, yields the
following equilibrium output,
If we normalise the fixed nominal exchange rate to one, the steadystate consumption function becomes
Note that in this symmetrical equilibrium, with PPP due to free trade, it
will also be the case that the real value of debt held overseas will be
the same in both countries, F /P = F/P . This fact, combined with
equations (8.34)(8.39), will determine the steady-state value of real
assets in the model, along with the equilibrium real interest rate. Since
consumers are not infinitely lived, the real interest rate is not identical
to consumers rate of time preference, but will be affected by the
outstanding stock of government liabilities, since these liabilities
constitute consumers net wealth.
2.2
Linearising the model around the steady state
We now proceed to log-linearise the model around this symmetrical
steady state. To illustrate this consider the labour supply equation
This is the same as the usual New Keynesian Phillips curve, except that
there now exists a terms-of-trade effect in addition to the usual
aggregate demand effect. There is also a distinction between the
inflationary impact of an increase in consumption (which will raise both
ct and yt , ceteris paribus) and an increase in exports or government
spending (which will raise yt alone, ceteris paribus) which is not
present in the usual New Keynesian Phillips curve. The reason for this
distinction is that workers need to be compensated in the form of
higher wages to supply the higher output, but in the case of an
increase in consumption workers require additional compensation as
they have an increased desire to substitute leisure for consumption.
This distinction will turn out to be critical in defining the fiscal policy
response required to eliminate the inflationary consequences of debt
disequilibrium following a shock. Finally, increasing taxation will be
inflationary owing to the detrimental effects this has on labour supply.
A similar expression can be derived in terms of foreign output prices:
where use was made of the fact that real interest rates (defined as
nominal rates relative to consumer price inflation) are the same across
all countries under EMU given the free trade in consumer goods.
Now we turn to the consumption function, (8.11), where loglinearisation yields
There are also the two global market-clearing conditions. Firstly, for
goods across the two economies,
ensure that the equilibrium debt stock is not too large, then the
value of f implied by this function is fairly small. In other words,
when debt disequilibrium has little impact on consumption, then
higher incountry one (the source of the shock), but it also declines
more rapidly there. The real exchange rate initially appreciates in
country one, because output is higher in country two. A similar
conclusion applies when feedback occurs through taxation, and for
an asymmetric inflation shock.
3.2.3 Symmetric economies and shocks, but asymmetric policies
Suppose both countries face the same shock, but their speed of
fiscal correction differs. This is a critical experiment in assessing the
appropriateness of the fiscal stability pact. Implicit in the pacts
formulation is the idea that lax fiscal control in one country could
impose costs on the other, and could jeopardise the ability of the
monetary authorities to control inflation. Our analysis in related
work (Leith and Wren-Lewis 2001) showed that this was the case if
one country applied little or no control over its public debt.
However, does the same apply if debt control is slow rather than
non-existent?
In the case of a demand shock and fiscal feedback through
government spending, different speeds of adjustment have little
differential effect on each country. In particular, the real exchange
rate is unchanged. This is because government spending is spread
equally across demand for each good, and consumers are
indifferent between each countrys debt. The only consequence of
one country reducing its speed of fiscal feedback is that it lowers
the average speed of correction for both countries. As we saw
above, with this shock slow adjustment is preferable (the matching
case). As a result, the country adjusting quickly imposes costs
(albeit small) on the country adjusting slowly! Much the same
applies in the case of a supply shock.
When fiscal feedback occurs through taxation, then results are
more interesting, because differences in taxation between countries
generate differences in supply and the real exchange rate. In the
case of a demand shock, debt falls and so the fiscal authorities
reduce tax rates. Suppose feedback in country one is fast ( f = 1),
and in country two slow (f = 0.5). The more rapid fall in taxes in
country one leads to greater labour supply in the short run, and
higher output. To sell the additional output, country ones real
exchange rate initially depreciates, but this is reversed after a few
years when country twos taxes become lower relative to country
one.
Slower adjustment in country two lowers the average speed of
adjustment, and we saw in the case of symmetrical policies that it
was preferable to adjust taxes quickly rather than slowly for a
demand shock. As a result, slow adjustment in country two raises
inflation in country one relative to the case where both countries
adjust quickly. However, the differences are tiny: inflation at an
not
iceable for supply rather than demand shocks, and even then they
are very small.
3.2.4 Asymmetric economies, symmetric policies and shocks
So far we have assumed that the two countries have an identical
structure. One of the most frequently analysed cases where
structure differs is where one country is more sluggish in its inflation
response. Indeed governments in some countries in the EU have
made a point of pressing their EU partners to undertake labour
market and other structural reforms in an attempt to make markets
there less rigid.
Consider the symmetrical demand shock analysed above, where
fiscal feedback occurs through government spending, and we
choose the matching value of f (f=0.5). Suppose price inertia in
country two is less than in country one. In our model inertia in both
goods and labour markets is captured by the alpha parameter. So
far we have assumed = 0.75 in both countries, which implies that
three-quarters of prices remain fixed each quarter. Suppose now
that = 0.5 in country two, but remains at 0.75 in country one.
This difference in inflation responsiveness leads to quite different
behavior in each country, even though the shock is symmetric.
Figure 8.8 looks at output in each country, and also plots the case
where = 0.75 in both countries.
two countries are less marked, as figure 8.9 shows. The fact that
differences in influence output much more than inflation in part
reflects the high demand elasticity we have assumed ( = 8). Small
movements in the real exchange rate generate large differences in
output.
The marked differences in output between the two countries lead
to very different profiles in government debt. After inflation erodes
debt in both countries, debt in country two is soon higher than base,
while in country one it always stays below base. At first sight this
might suggest that country two should reduce its debt
disequilibrium more rapidly than country one. However, our results
above suggest that rapid debt correction is not obviously desirable.
This is confirmed by various simulation experiments not reported
here: increasing the relative speed of fiscal feedback in country two
does not lead to any clear benefits in terms of inflation or output for
either country. One issue that would be worth pursuing in further
research is whether asymmetric economic structures might
generate a role for a countercyclical fiscal policy.
4. Conclusion
In this chapter we constructed a two-country model which contained a
number of features which broke the distinction between Ricardian and
non-Ricardian policies highlighted by the Fiscal Theory of the Price Level
(Woodford 1998). Specifically, our two economies featured overlapping
generations of consumers who did not expect to live for ever as a result