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Public Investment under Debt, Tax andMoney Financing
L. Burlon A. Locarno A. Notarpietro M. Pisani
Banca d’Italia
Central Bank Macro Modelling WorkshopBanque de France
Paris, 16-17 November 2017
The views expressed here are those of the authors and should not
be attributed to the Bank of Italy
Goal
I Evaluate the macroeconomic impact on the euro area of anincrease in public investment in infrastructures underalternative assumptions about funding sources (fiscal side)and monetary policy stance
Motivation
I Increase in public spending in infrastructure has been proposedas a way to address weak aggregate demand and low inflation
I IMF (2014), European Commission (2015), OECD (2016)
I Sustain aggregate demand in the short term, expand supplycapacity in the long run
I Exploit exceptionally low levels of borrowing costs (role ofmonetary policy)
I Cross-country coordination of fiscal stimuli may favor bilateralexports
I Cons: lack of fiscal space, implementation delays, inefficiencies
Contribution
I Model-based assessment: calibrated 3-region New KeynesianDSGE model: two euro-area (EA) regions (”Home” and restof EA, ”REA”) and rest of the world (”RW”)
I EA: monetary union, Home and REA share same monetarypolicy and exchange rate
I Fiscal policy is country-specific. Public sector leviesdistortionary taxes, issues debt, consumes and invests ininfrastructure
I Public capital enters production function of domestic goodswith private capital and labor
I Non-standard monetary policy measures (quantitative easing)have real effects via financial market segmentation
Preview of results
I Sizable medium-long term fiscal multipliers (> 1)
I If coupled with non-standard monetary policy (forwardguidance and quantitative easing), fiscal multipliers becomevery large (> 3 at peak), fiscal stimulus is self-financing andinflation increases
I Cross-country coordination enchances expansionary effects
I Funding matters: Debt-financed fiscal stimulus isgrowth-friendly in the short run but not in the long run,compared to tax-financed
I In all cases, efficiency in public investment implementation iscrucial for the stimulus to have sizable real effects
Related literature
I Coenen et al. (2013): impact on EA of European EconomicRecovery Plan (2008)
I Elekdag and Muir (2014): macroeconomic impact of publicinvestment in infrastructure in EA and Germany
I Blanchard et al. (2015): effects of fiscal expansions inEuropean core economies
I Abiad et al. (2016): empirical evidence on public investmenteffectiveness (role of efficiencty and financing)
I DeJong et al. (2017): effectiveness of public investment inthe EU
Road map
I Model setup: most relevant features, calibration
I Simulated scenarios and results
I Conclusions
Model structure: standard building blocks
I World economy: two euro-area (EA) regions (”Home” andrest of EA, ”REA”) and rest of the world (”RW”)
I Each region: final consumption and investment goods,intermediate tradable (T) and nontradable (NT) goods
I T and NT sectors use private capital, labor and public capital
I Nominal price and wage rigidities: forward-looking Phillipscurve
I Monetary policy: standard and non-standard measures(forward guidance, quantitative easing)
I Financial market segmentation allows non-standard monetarypolicy to have real effects
Model setup: fiscal policy
I Fiscal policy is country-specific. Public sector:
I Lump-sum transfers, public consumption, public investment ininfrastructure
I Distortionary taxes on labor income, capital income,consumption
I Public debt stabilized via a fiscal rule that adjusts lump-sumtransfers to achieve desired debt target
I Government budget constraint:
BSG ,t −BS
G ,t−1Rt−1+PL,tBLG ,t −
∞
∑s=1
κs−1BLG ,t−s ≤ PN,tCG ,t +PIG ,t IG ,t +TRt −Tt ,
Model setup: fiscal policyI Public debt is stabilized via lump-sum transfers:
TRt
TRt−1=
(bsG ,t
b̄sG
)−φ1
,
I Public capital accumulation
KG ,t−1 = (1− δG )KG ,t−2 + AIG ,t−1−N ,
where AIG ,t−1−N , with N ≥ 1, is authorized governmentinvestment in period t − 1−N (time-to-build lags).
I Government investment actually implemented at time t is
IG ,t =N−1∑n=0
bnAIG ,t−n
N−1∑n=0
bn = 1
Model setup: public capital in production
I Home intermediate tradable sector: production function ofgeneric firm i :
YT ,t (i) = KPT ,t (i)
α1T LUT ,t (i)α2T LRT ,t (i)
α3T (KG ,t−1)1−α1T−α2T−α3T
I Similar production function holds in the intermediatenontradable sector
I Public capital taken as given by firms
Model setup: financial segmentation
I Following Chen et al. (2012): imperfect substitutabilityamong financial assets, to relax Wallace neutrality
I In each EA region, two types of households:
I Restricted households only invest in domestic long-termsovereign bonds and own share of domestic capital producersdetails
I Unrestricted households have access to multiple financialassets and invest in physical capital (through capitalproducers, alongwith the unrestricted)
I Long-term sovereign bonds are perpetuities payingexponentially decaying coupon (see Woodford 2001) details
I Non-standard monetary policy: purchases by central bank ↓long-term interest rates =⇒ restricted households ↑consumption and investment
Model setup: capital producers
I Capital producers accumulate physical capital by demandingfinal investment goods subject to quadratic adjustment costson investment change
I Rent out capital to the domestic firms
I Maximize profits with respect to capital and investmenttaking prices as given
I Evaluate returns according to a weighted average of restrictedand unrestricted households’ stochastic discount factors(weights are the corresponding population shares)
I Net revenues are rebated (lump-sum) to domestic restrictedand unrestricted households according to their correspondingshares
Model setup: monetary policy
I Standard (Taylor-rule based) monetary policy
(Rt
R̄
)4
=
(Rt−1R̄
)4ρR(
ΠEA,t,t−3Π̄4
)(1−ρR )ρπ(
GDPEA,t
GDPEA,t−1
)(1−ρR )ρGDP
.
I Non-standard monetary policy measures: forward guidance(FG) on policy rate and purchases of EA long-term sovereignbonds
I Home long-term sovereign bonds:∫ nλR
0BLR,t (j
′)dj ′+∫ n
nλR
BLU,t (j)dj + BL
PSPP,t = BLG ,t ,
I A similar condition holds for the REA region
Long-term sovereign bonds market clearing
Unrestricted
Restricted Government
Foreign Households
PSPP
sovereign long-term
Calibration
I Parameters set in line with literature and to match EA greatratios. Home region is a relatively small country (20% of EAGDP)
I Set restricted households’ discount factor to obtain along-short term spread of 1.8pp on sovereign bonds
I Share of restricted households: 0.25 (in Home and REA).Lack of micro-evidence
I Short-term public debt (ratio to GDP): 13% in Home, 8% inREA. Long-term: 120% in Home, 93% in REA. Averageduration: 8 years
I Central bank purchases are proportional to GDP share of eachregion in EA (PSPP follows capital keys of Eurosystemmembers)
Simulated scenarios
1. Home increase in public investment (debt financed).Monetary policy:
I Taylor ruleI 2-year forward guidance (FG)
2. EA-wide increase in public investment. Monetary policy:I Taylor ruleI 2-year forward guidance (FG)I FG + Quantitative easing
3. Alternative forms of financing (EA-wide increase in pub. inv.):
I Distortionary tax-financed increaseI Monetary accommodation
4. Sensitivity analysis: efficiency in public investment increase(no direct supply-side effect, time-to-build)
Home increase in public investment
I Home government increases public investment by 1% of GDPfor 5 years, then gradually back to baseline level
I During fiscal stimulus, fiscal rule not active: after 5th yearlump-sum transfers stabilize public debt
Home increase Home increase+FG1st year LR 1st year LR
HomeGDP 0.7 1.5 0.7 1.5Inflation -0.1 0.0 0.0 0.0Short-term interest rate 0.0 0.0 0.0 0.0Long-term interest rate 0.1 0.1 0.1 0.1Public deficit 1.0 -0.4 1.0 -0.4Public debt -1.5 3.8 -1.6 3.6
REAGDP 0.0 0.0 0.1 0.0
Home public investment and FG: Home variables
10 20 30 400
1
2GDP
FG
No FG
10 20 30 40-0.2
0
0.2Annualized inflation
FG
No FG
10 20 30 40-2
0
2Consumption
FG
No FG
10 20 30 40-2
0
2Private investment
FG
No FG
10 20 30 40-5
0
5Exports
FG
No FG
10 20 30 400
1
2Imports
FG
No FG
10 20 30 400
0.5
1Labor
FG
No FG
10 20 30 400
1
2Real wage
FG
No FG
10 20 30 400
0.01
0.02Policy rate
FG
No FG
10 20 30 40-0.1
0
0.1Euro nominal exchange rate (increase=appr.)
FG
No FG
10 20 30 40-2
0
2Public deficit
FG
No FG
10 20 30 400
0.1
0.2Long-term interest rate
FG
No FG
10 20 30 40-5
0
5Total (ST+LT) public debt
FG
No FG
10 20 30 40-5
0
5Private holdings of long-term debt
FG
No FG
EA increase in public investment
I Increase in public investment (1% of GDP) simultaneouslyimplemented in Home and REA
I Same assumptions as above
EA increase EA increase+FG1st year LR 1st year LR
HomeGDP 0.9 1.7 1.9 1.8Inflation 0.2 0.0 1.1 0.0Short-term interest rate 0.1 -0.1 0.0 -0.1Long-term interest rate 0.1 0.0 0.0 -0.1Public deficit 0.9 -0.5 0.3 -0.3Public debt -2.2 2.4 -3.4 -0.9
Table: EA public investment increase and FG.
EA increase EA increase+FG1st year LR 1st year LR
REAGDP 0.9 1.5 1.8 1.6Inflation 0.2 -0.1 1.3 -0.1Long-term interest rate 0.1 -0.0 0.0 -0.1Public deficit 0.9 -0.5 0.4 -0.3Public debt -1.5 2.8 -2.6 0.4
EA public investment and FG: Home variables
10 20 30 400
2
4GDP
FG
No FG
10 20 30 40-2
0
2Annualized inflation
FG
No FG
10 20 30 400
1
2Consumption
FG
No FG
10 20 30 40-5
0
5Private investment
FG
No FG
10 20 30 400
2
4Exports
FG
No FG
10 20 30 400
2
4Imports
FG
No FG
10 20 30 400
2
4Labor
FG
No FG
10 20 30 400
1
2Real wage
FG
No FG
10 20 30 40-0.5
0
0.5Policy rate
FG
No FG
10 20 30 40-5
0
5Nominal exchange rate (increase=appreciation)
FG
No FG
10 20 30 40-1
0
1Public deficit
FG
No FG
10 20 30 40-0.2
0
0.2Long-term interest rate
FG
No FG
10 20 30 40-5
0
5Total (ST+LT) public debt
FG
No FG
10 20 30 40-5
0
5Private holdings of long-term debt
FG
No FG
EA public investment and FG: REA variables
10 20 30 400
2
4GDP
FG
No FG
10 20 30 40-2
0
2Annualized inflation
FG
No FG
10 20 30 400
1
2Consumption
FG
No FG
10 20 30 40-5
0
5Private investment
FG
No FG
10 20 30 400
2
4Exports
FG
No FG
10 20 30 400
1
2Imports
FG
No FG
10 20 30 400
2
4Labor
FG
No FG
10 20 30 400
1
2Real wage
FG
No FG
10 20 30 40-0.5
0
0.5Interest rate
FG
No FG
10 20 30 40-5
0
5Nominal exchange rate (increase=appreciation)
FG
No FG
10 20 30 40-1
0
1Public deficit
FG
No FG
10 20 30 40-0.2
0
0.2Long-term interest rate
FG
No FG
10 20 30 40-5
0
5Total (ST+LT) public debt
FG
No FG
10 20 30 40-5
0
5Private holdings of long-term debt
FG
No FG
EA public investment and quantitative easing
I Same assumptions as above, plus quantitative easing (PublicSector Purchase Programme)
I EA’s central bank purchases: euro 180 billion per period forseven quarters (January 2015 Eurosystem PSPP)
I Long-term sovereign bond purchases in Home and REAproportional to corresponding region size as a share of EA
Table: EA public investment, FG, and PSPP
EA increase+FG FG and PSPP1st year LR 1st year LR
HomeGDP 1.9 1.8 3.0 2.6Inflation 1.1 0.1 2.1 -0.1Short-term interest rate 0.0 -0.1 0.0 0.0Long-term interest rate 0.0 -0.1 -0.5 -0.3Public deficit 0.3 -0.3 -0.6 -0.1Public debt -3.4 -0.9 -1.7 -6.7
EA public investment, FG, and PSPP: Home variables
10 20 30 400
2
4GDP
w/o PSPP
with PSPP
10 20 30 40-5
0
5Annualized inflation
w/o PSPP
with PSPP
10 20 30 400
2
4Consumption
w/o PSPP
with PSPP
10 20 30 400
5
10Private investment
w/o PSPP
with PSPP
10 20 30 400
2
4Exports
w/o PSPP
with PSPP
10 20 30 400
5Imports
w/o PSPP
with PSPP
10 20 30 400
5
10Labor
w/o PSPP
with PSPP
10 20 30 40-5
0
5Real wage
w/o PSPP
with PSPP
10 20 30 40-0.5
0
0.5Policy rate
w/o PSPP
with PSPP
10 20 30 40-5
0
5Nominal exchange rate (increase=appreciation)
w/o PSPP
with PSPP
10 20 30 40-1
0
1Public deficit
w/o PSPP
with PSPP
10 20 30 40-0.5
0
0.5Long-term interest rate
w/o PSPP
with PSPP
10 20 30 40-10
0
10Total (ST+LT) public debt
w/o PSPP
with PSPP
10 20 30 40-20
-10
0Private holdings of long-term debt
w/o PSPP
with PSPP
EA public investment, FG, and PSPP: REA variables
10 20 30 400
2
4GDP
w/o PSPP
with PSPP
10 20 30 40-5
0
5Annualized inflation
w/o PSPP
with PSPP
10 20 30 400
2
4Consumption
w/o PSPP
with PSPP
10 20 30 400
5
10Private investment
w/o PSPP
with PSPP
10 20 30 40-5
0
5Exports
w/o PSPP
with PSPP
10 20 30 400
2
4Imports
w/o PSPP
with PSPP
10 20 30 400
5
10Labor
w/o PSPP
with PSPP
10 20 30 400
1
2Real wage
w/o PSPP
with PSPP
10 20 30 40-0.5
0
0.5Interest rate
w/o PSPP
with PSPP
10 20 30 40-5
0
5Nominal exchange rate (increase=appreciation)
w/o PSPP
with PSPP
10 20 30 40-1
0
1Public deficit
w/o PSPP
with PSPP
10 20 30 40-0.5
0
0.5Long-term interest rate
w/o PSPP
with PSPP
10 20 30 40-10
0
10Total (ST+LT) public debt
w/o PSPP
with PSPP
10 20 30 40-20
0
20Private holdings of long-term debt
w/o PSPP
with PSPP
EA public investment: distortionary taxes and money
I EA increase in public investment + FG
I Increase in public investment financed by ↑ distortionary taxrates on labor, capital, and consumption
I Increase in taxes lasts for 5 years, then lump-sum transfers areused
I Alternatively: central bank buys and permanently rolls over anamount of sovereign bonds equal to increase in EA publicinvestment
I Additional supply of base money - used by fiscal authorities tobuy additional goods - contributes to keep interest rates low
Table: EA public investment financing: distortionary taxes and money
EA increase+FG Tax increase Money financing1st year LR 1st year LR 1st year LR
HomeGDP 1.9 1.8 1.6 1.9 2.3 2.1Inflation 1.1 -0.0 0.9 -0.1 1.5 0.0Short-term int. 0.0 -0.1 0.0 -0.1 0.0 -0.1Long-term int. 0.0 -0.1 -0.1 -0.1 -0.2 -0.2Public deficit 0.3 -0.3 -0.6 0.0 0.0 -0.3Public debt -3.4 -0.9 -2.6 -3.7 -2.8 -3.6
Sensitivity analysis
I Efficiency in implementing public investment decisions is key
I Lack of efficiency associated with
I no accumulation of public capital (no direct impact of publicinvestment on supply-side)
I or: slow accumulation of public investment (time-to-build,more gradual impact on supply side )
Table: EA public investment and PSPP: no-public capital accumulationand time-to-build
FG and PSPP No acc. of public K Time-to-build1st year LR 1st year LR 1st year LR
HomeGDP 3.0 2.6 1.9 0.5 1.5 2.2Inflation 2.1 -0.1 1.3 0.0 1.5 -0.2Public deficit -0.6 -0.1 -0.1 0.0 -0.9 0.1Public debt -1.7 -6.7 -0.3 -1.5 -0.3 -3.7
Conclusions
I Benefits of fiscal policy cooperation, synergies between fiscaland monetary policy
I Fiscal multiplier can be > 1 and close to 2: large GDP gains,but not enough to reduce debt-to-GDP ratio
I Larger GDP gains with simultaneous fiscal stimulus in wholeEA and monetary policy accommodation
I Monetary policy role is crucial: FG + QE =⇒ fiscalmultiplier > 3 at peak and investment spending isself-financing
I Financing method is relevant: tax-financed stimulus is lesseffective; debt financing more growth-friendly in the short runbut not in the long run
I Effectiveness of fiscal stimulus enhanced if implementationoccurs efficiently and without delays
Model setup: fiscal policy
I The short-term bond is a one-period nominal bond issued inthe domestic bond market that pays the (gross) monetarypolicy interest rate Rt .
I The gross yield to maturity at time t on the long-term bond is
RLt =
1
PLt
+ κ.
Back
Model setup: restricted households
I Restricted households have access only to the market oflong-term sovereign bonds. The budget constraint is
PLt B
LR,t
(j ′)−
∞
∑s=1
κs−1BLR,t−s
(j ′)
(1)
= Πproft
(j ′)+WR,t
(1− τ`
t
) (j ′)LR,t
(j ′)
−Pt (1 + τct )CR,t
(j ′)− ACW
R,t
(j ′)
,
where BLR,t is the amount of long-term sovereign bonds, Πprof
t
is profit from ownership of the Home capital producers. Thelong-term sovereign bonds have price PL,t and are formalizedas perpetuities paying an exponentially decaying couponκ ∈ (0, 1], following Woodford (2001) Back