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This PDF is a selection from a published volume from the National Bureau of Economic Research Volume Title: NBER International Seminar on Macroeconomics 2010 Volume Author/Editor: Richard Clarida and Francesco Giavazzi, organizers Volume Publisher: University of Chicago Press Volume ISBN: 978-0-226-10736-3 (cloth); 0-226-10738-8 (paper) Volume URL: http://www.nber.org/books/clar10-1 Conference Date: June 18-19, 2010 Publication Date: September 2011 Chapter Title: Comment on "Asymmetric Shocks in a Currency Union with Monetary and Fiscal Handcuffs" Chapter Authors: Bianca De Paoli Chapter URL: http://www.nber.org/chapters/c12214 Chapter pages in book: (p. 137 - 141) Comment Bianca De Paoli, Bank of England and Centre for Economic Performance, London School of Economics Erceg and Lindé use a fully fledged general equilibrium model to address a very topical issue. By characterizing the euro area with two distinct blocks of countries, the paper assesses the cross-border spillovers from a fiscal contraction in one of the blocks. The authors evaluate how the zero lower bound constraint on monetary policy affects these spillovers. The exercise compares the case of a unilateral contraction in a small country versus a contraction in a larger block of countries. It shows that the fiscal multiplier and the spillovers are larger when policy is constrained. Moreover, a small country gains from having a coordinated policy with other countries only if policy is unconstrained. I. Related Literature The paper provides an interesting contribution given the state of fiscal affairs in the euro area. But apart from a topical application, I believe that the paper could speak more broadly to the literature. In particular, I believe that the results are in line with the ones found in the literature that relate fiscal multipliers and monetary policy regimes. The authors could also relate their findings with the results documented in the literature on cross-country spillovers and comovements of international business cycles. Using a closed economy framework, Christiano, Eichenbaum, and Rebelo (2011) and Eggertsson (2011) (among others) have shown that the fiscal multiplier can be significantly larger when monetary policy is constrained by the zero lower bound (ZLB) on nominal interest rates. Erceg and Lindé demonstrate that the same holds in an open economy. But both closed and open economy results are possibly a part of a more general conclusion: as thoroughly shown by Davig and Leeper (2009), a passive monetary policy regime increases the size of the fiscal multiplier. B 2011 by the National Bureau of Economic Research. All rights reserved. 978-0-226-10736-3/2011/2010-0031$10.00 This content downloaded from 66.251.73.4 on Thu, 2 Jan 2014 13:50:27 PM All use subject to JSTOR Terms and Conditions 138 De Paoli In the open economy context, the results could also be discussed vis-à-vis the findings of Corsetti, Meier, and Müller (2010b), who present some empirical evidence that when monetary policy is constrained by a fixed exchange rate regime, the fiscal multiplier is amplified. In addition, the paper could link its results to the ones found in the literature on cross-country spillovers. Backus, Kehoe, and Kydland (1992) show that standard models cannot generate significant output comovements between countries if business cycles are driven by productivity shocks. Subsequently, Stockman and Tesar (1995) demonstrate that preference shocks are important in generating cross-country spillovers that help explain international business cycle comovement. Bodenstein, Erceg, and Guerrieri (2009) propose a framework in which, under the ZLB constraint, spillovers from foreign shocks may be significant, also increasing the cross-country correlation in output. In light of these findings, I believe that the authors could emphasize how their result can complement the literature. In particular, the paper could emphasize the result that fiscal shocks, which as in Stockman and Tesar (1995) and Bodenstein et al. (2009) are demand-side shocks, can generate significant spillovers when the ZLB constraint is binding. II. On the Role of Different Model Features The model proposed by the authors is quite sophisticated. Having an allencompassing model is useful in order to characterize the euro area environment and answer some relevant questions on the conduct of fiscal policy among member countries. But, from a theoretical point of view, it would be interesting to understand what the role of the different model features is in generating the results. Also, the authors could discuss whether these would hold in a simpler framework. The presence of hand-to-month consumers is crucial in generating significant effects from fiscal shocks. Although this is apparent from the sensitivity analysis conducted by the authors, I believe that greater attention should be given to the issue. The authors could explore the mechanism behind such an observation and, again, relate it to studies documenting similar findings. The literature has shown mixed assessments of whether the presence of hand-to-mouth consumers or credit-constrained households significantly changes the transmission mechanism of shocks. For example, the results in Meier and Müller (2006) suggest that this is not the case, whereas Christiano, Motto, and Rostagno (2007) argue otherwise. When looking specifically at fiscal shock, the literature appears to show more of a consensus. Since Perotti (1999), works such as Galí, López-Salido, This content downloaded from 66.251.73.4 on Thu, 2 Jan 2014 13:50:27 PM All use subject to JSTOR Terms and Conditions Comment 139 and Vallés (2007) and Roeger and Veld (2009) obtain the result that constrained households are essential in reducing the crowding out of fiscal shocks and increasing the fiscal multiplier. This is in fact the reason why, in the exercise proposed by Erceg and Lindé, spillovers almost disappear when all consumers are forward looking. In this case, the expectation of future tax cuts would reduce the effect of the fiscal contraction and the consequent cross-border effects. It would also be of interest to investigate the implications of the particular nature of the government spending assumed in the model. I believe that the specification chosen by the authors has some consequences for the degree of international spillovers and, thus, should be explored in greater detail. Corsetti, Meier, and Müller (2010a) have shown that a debt-stabilizing government spending process (rather than a purely exogenous one) can increase the fiscal multiplier by acting on the expectations of forward-looking agents. Under a debt-stabilizing specification, agents would expect a fiscal contraction to be followed by future increases in public spending. This would imply higher future nominal interest rates—given that the central bank responds to higher expected inflation. And higher long-term interest rates could in turn increase the impact of the fiscal contraction today. So the purely exogenous nature of government spending could understate the effect of the shocks. However, the paper assumes that private and public sectors have the same preferences toward the basket of consumption goods, which is composed of domestic and foreign goods. But most open economy frameworks assume that the government consumes more nontradable goods (or domestically produced goods) than domestic households. It would be interesting to understand whether this specification, which implies a smaller “home bias” in government consumption than commonly assumed, overstates the degree of international spillovers. Finally, the results in the paper are based mostly on pure aggregate demand effects without a role for movements in international relative prices. In the model, a reduction in public spending in a block of countries has a direct impact on the demand for foreign-produced goods. But there appears to be little or no expenditure-switching effect, which could make a foreign contraction be positive news for the home economy. III. On the Methodology: Solving the Model under the ZLB The solution method proposed by the authors is based on perfectforesight simulations. But what are the implications of introducing a fully stochastic environment? As discussed in Nakov (2008, 89), “when the This content downloaded from 66.251.73.4 on Thu, 2 Jan 2014 13:50:27 PM All use subject to JSTOR Terms and Conditions 140 De Paoli natural real rate is close to zero, private-sector expectations reflect the asymmetry in the central bank’s problem: a positive shock in the following period is expected to be neutralized, while an equally probable negative one is expected to take the economy into a liquidity trap. This gives rise to a ‘deflationary bias’ in expectations, which in a forward-looking economy has an immediate impact on the current evolution of output and prices.” This suggests that the assumption of perfect foresight might underestimate ex ante real interest rates. As a result, it could underestimate the impact of the adverse government spending shock, the size of the fiscal multiplier, and the consequent cross-border spillover. Endnote The views expressed in this comment are those of the author and not necessarily those of the Bank of England. References Backus, D., P. Kehoe, and F. Kydland. 1992. “International Real Business Cycles.” Journal of Political Economy 100:745–75. Bodenstein, M., C. Erceg, and L. Guerrieri. 2009. “The Effects of Foreign Shocks When Interest Rates Are at Zero.” International Finance Discussion Paper no. 983, Board of Governors of the Federal Reserve System, Washington, DC. Christiano, L., M. Eichenbaum, and S. Rebelo. 2011. “When Is the Government Spending Multiplier Large?” Journal of Political Economy 119, no. 1:78–121. Christiano, L., R. Motto, and M. Rostagno. 2007. “Shocks, Structures or Monetary Policies? The Euro Area and the US after 2001.” Working Paper no. 774, European Central Bank, Frankfurt. Corsetti, G., A. Meier, and G. Müller. 2010a. “Cross-Border Spillovers from Fiscal Stimulus.” International Journal of Central Banking 6, no. 1:5–37. ———. 2010b. “When, Where and How Does Fiscal Stimulus Work?” Paper presented at the conference “Interaction between Fiscal and Monetary Policies,” Bank of Spain, February, http://www.bde.es/webbde/GAP/ Secciones/SalaPrensa/Agenda/Eventos/10/Feb/session5. Davig, T., and E. Leeper. 2009. “Monetary-Fiscal Interactions and Fiscal Stimulus.” Manuscript, Indiana University. Eggertsson, G. 2011. “What Fiscal Policy Is Effective at Zero Interest Rates?” NBER Macroeconomics Annual 2010:59–112. Galí, J., D. López-Salido, and J. Vallés. 2007. “Understanding the Effects of Government Spending on Consumption.” Journal of the European Economic Association 5, no. 1:227–70. Meier, A., and G. Müller. 2006. “Fleshing Out the Monetary Transmission Mechanism: Output Composition and the Role of Financial Frictions.” Journal of Money, Credit and Banking 38, no. 8:2099–2134. Nakov, A. 2008. “Optimal and Simple Monetary Policy Rules with Zero Floor on the Nominal Interest Rate.” International Journal of Central Banking 4, no. 2:73–127. This content downloaded from 66.251.73.4 on Thu, 2 Jan 2014 13:50:27 PM All use subject to JSTOR Terms and Conditions Comment 141 Perotti, R. 1999. “Fiscal Policy in Good Times and Bad.” Quarterly Journal of Economics 114, no. 4:1399–1436. Roeger, W., and J. Veld. 2009. “Fiscal Policy and Credit Constrained Households.” European Economy Economic Paper no. 357, http://ec.europa.eu/ economy_finance/publications/publication13839_en.pdf. Stockman, A., and L. Tesar. 1995. “Tastes and Technology in a Two-Country Model of the Business Cycle: Explaining International Comovements.” American Economic Review 85, no. 1:168–85. This content downloaded from 66.251.73.4 on Thu, 2 Jan 2014 13:50:27 PM All use subject to JSTOR Terms and Conditions This content downloaded from 66.251.73.4 on Thu, 2 Jan 2014 13:50:27 PM All use subject to JSTOR Terms and Conditions