Download This PDF is a selection from a published volume from... Bureau of Economic Research Volume Title: NBER International Seminar on Macroeconomics

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.
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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,
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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
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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
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Comment
141
Perotti, R. 1999. “Fiscal Policy in Good Times and Bad.” Quarterly Journal of
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