Download Dejan Krusec

Dejan Krušec
PhD Student
European University Institute
Rethymno, 28. 8. 2003
Outline of research in the area of EMU –
Current state and future prospects
(At least) Three topics of interest:
Fiscal and monetary policy mix in the EMU
and accession (i.e. acceding) countries
2. Exchange rate and inflation in accession
countries
3. “Equilibrium” level of deficit in EMU and
accession countries
1.
Fiscal and monetary policy mix in the EMU
and accession (i.e. acceding) countries
Motivation:
Idea: What if ECB triggers with its e.g. tight monetary policy
shocks loose fiscal policy in Eurozone countries and
therefore countries get into the risk of exceeding the 3%
deficit bound? Even worse scenario if some countries
loosen and other tighten their fiscal policy as a response.
- important question for EMU: do government in response to
monetary tightening tighten or loosen fiscal policy and
vice versa – implications for the SGP, same question for
accession countries,
- distinguish comovement of the two policies over the
business cycle from reaction of one the shock of the
other – VAR suitable technique.

-
Research background: not much VAR method research in this
area, some cross-section studies, e.g.
Studies of Melitz (1997) and Wyplosz (1999) find that monetary
and fiscal policy tend to move in the opposite directions. Melitz
(1997, 5) uses in his study two-stage least squares and threestage least squares method the interaction on the sample of 19
OECD countries. Both authors: evidence of strategic
substitutability between the two government policies i.e. looser
fiscal policy promotes tighter monetary policy and vice versa.
According to these studies we would e.g. expect the
government spending to increase and taxation to decrease in
response to tighter monetary policy i.e. in response to the
increase in the interest rate - central bank’s instrument.
Why VAR approach: better isolation of shocks and responses
(because of difference between three types of e.g. fiscal
shocks and responses;
 first the automatic response of taxes and
government spending to innovations in output, prices
and interest rates,
 then the discretionary response of fiscal policy
to output prices and interest rates and finally
 the structural fiscal shocks, which are unlike the
reduced form residuals not correlated with each other
and with all other structural shocks.
- My previous research on fiscal-monetary policy
mix for four OECD countries (Australia, Great
Britain, Canada and USA) in a structural VAR
framework
- Method: structural VAR (five variables: output,
inflation government spending, taxation, central
bank’s interest rate), with the identification
procedure following Blanchard and Perotti (QJE
2002):
3-step identification procedure



first step in the identification procedure fiscal variables do not react to unexpected price or
output movements within a quarter which sets the
discretionary response of government spending
and taxes to movement and output to zero.
second step – automatic responses: compute
price and output elasticities of taxes, and price
elasticity of government spending,
third step: - determine which of the two
fiscal shocks comes first – Cholesky ordering,
determine order of other variables.
Table: Synthetic presentation of results
Response
of... to...
Gt t o
It
Tt to
It
Gt t o
I t
T t t o
I t
Gt t o
rI t
Tt to
rI t
Australia
Canada
Great Britain
USA
Whole
To
1980
From
1980
Whole
To
1980
From
1980
Whole
To
1980
From
1980
Whole
To
1980
From
1980
+
+
+
+
+
+
+
0
+
0
0
-
0
0
0
-
+
-
+
+
-
-
0
-
+
na
na
+
na
na
+
na
na
0
na
na
0
na
na
-
na
na
+
na
na
-
na
na
0
+
0
+
+
+
0
-
-
0
0
0
0
0
0
0
+
-
+
+
0
0
0
-
Findings
Countries do not have the same fiscal-monetary policy
mix, e.g.
 fiscal and monetary policy acted as substitutes
in Australia, Canada and partly in United States,
 the degree of substitutability is not higher in the
period from 60s up to 1980 than after that date (from
the 80s to the year 2001),
 Great Britain acts as an ‘outlier’ since the
evidence shows that fiscal and monetary policy acted
more like strategic complements, especially in the
period before 1980.
Alternative approach: five variable cointegrated VAR.
Why?
1. Suitable framework to separate automatic responses of fiscal, monetary
policy to economic activity from fiscal and monetary policy shocks
(i.e. separate comovement over the business cycle from pure reactions
of the two policies to each-other). We would get three co-integrating
relations, one for automatic response of government spending to GDP
and inflation movements, the other for automatic response of taxation
to GDP and inflation movements and the money demand equation.
2. No need to get disaggregated data on taxes and government spending
to compute price and output elasticities
3. It is possible to determine which of the two policies comes first i.e. is
weakly exogenous with respect to the other and with respect to output
and price movements.
4. Cholesky ordering of variables needed only to identify the shocks once
cointegration is accounted for.
Same method for accession countries, comparison of
responses, implication for ECB.
Same method applied ot Eurozone as a whole
with the aggregation like in e.g. Artis and
Beyer (2003?), but the question of
usefullness of such aggregation since no
SGP before 1999, therefore variables
combine differently then after 1999.
2. Exchange rate and inflation in accession
countries
- Well known question of how to enter into the ERM II and
whether or not the Maastricht inflation criterium is too
tight
Two potential problems for accession countries:
1.
Balassa-Samuelson effect (driven by productivity)
2.
Exchange rate pass-through (driven by inflation
expectations in a small open economy)
Existing studies analyse both effects separately, but no
analysis of both in the same framework.
Proposed method
Analyse both effects together in a co-integrated VAR framework, where
we have four variables:
- productivity in the tradable sector,
- money supply,
- exchange rate,
- inflation rate (or difference of domestic and Eurozone inflation rate).
We expect to have two cointegrating relationships, since we have a policy
variable and an exogenous variable and two endogenous variables.
Existing study of Coricelli et al. (2002) on exhange rate pass-through does
not take into account the Balassa-Samuelson effect.
First cointegrating relation (automatic response
of...):
productivity combined with exchange rate and
inflation rate – Balassa Samuelson effect, LR test
of significance of parameteres,
Second cointegrating relation:
Exchange rate pass through - money supply
combined with exchange rate and inflation rate
(and LR test).
Possibilities of the method
Checking for interdependence of the two effects in
the direction that the productivity growth shock
may trigger the money supply growth and
exchange rate adjustment which in turn induces
inflation.
If this is empirically true, productivity effects
inflation directly and through the monetary policy
adjustment.
3. Equilibrium level of deficit in EMU and
accession countries
Idea: What if EMU and accession countries have
different „equilibrium“ levels of deficit, what if
for some countries it is nested in institutions that
they have higher budget deficits in absence of any
shocks, while others run balanced budgets ór even
budget surpluses?
- Scenario: High „equilibrium“ deficit + recession
or negative supply or demand shock could mean
exceeding the 3% deficit bound

-
-
Could work in the same cointegrated VAR
framework with variables included:
GDP,
Inflation,
CB‘s interest rate,
deficit.
The framework allows to do the LR test whether deficit
„equilibrium“ response to the GDP and inflation
movements are significantly different between the
countries. Additionally, we can test for responses of the
deficit to the shocks in the CB‘s interest rate.