This paper shows that productive government investment can improve an economy’s external competitiveness and stimulate private investment. Daragh Clancy European Stability Mechanism Pascal Jacquinot European Central Bank Matija Lozej Central Bank of Ireland Disclaimer This Working Paper should not be reported as representing the views of the ESM. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the ESM or ESM policy. Working Paper Series | 4 | 2015 Government expenditure composition and fiscal policy spillovers in a small open economy within a monetary union
Transcript
This paper shows that productive government investment can improve an economy’s external competitiveness and stimulate private investment.
Daragh ClancyEuropean Stability Mechanism
Pascal JacquinotEuropean Central Bank
Matija Lozej Central Bank of Ireland
DisclaimerThis Working Paper should not be reported as representing the views of the ESM.The views expressed in this Working Paper are those of the author(s) and do notnecessarily represent those of the ESM or ESM policy.
Working Paper Series | 4 | 2015
Government expenditure composition and fiscal policy spillovers in a small open economy within a monetary union
DisclaimerThis Working Paper should not be reported as representing the views of the ESM. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the ESM or ESM policy.No responsibility or liability is accepted by the ESM in relation to the accuracy or completeness of the information, including any data sets, presented in this Working Paper.
Government expenditure composition and fiscal policy spillovers in a small open economy within a monetary union
Daragh Clancy1 European Stability Mechanism
Pascal Jacquinot2 European Central Bank
Matija Lozej3 Central Bank of Ireland
*The views contained here are those of the authors and not necessarily those of their respective institutions. This is an updatedversion of an earlier paper circulated as “The effects of government spending in a small open economy within a monetary union”. This work was initiated while Daragh Clancy and Matija Lozej were visiting the European Central Bank Monetary Policy Research Division, who are thanked for their hospitality. We are grateful to Gabriel Fagan, Petr Sedláček, participants at the 20th International Conference of the Society for Computational Economics and Finance, the 29th Irish Economic Association Annual Conference and attendees of seminars at the Central Bank of Ireland, European Stability Mechanism and the University of Primorska for comments and suggestions that have helped to improve the paper. However, all errors remain our own.1European Stability Mechanism, 6a Circuit de la Foire Internationale, L-1347 Luxembourg, Luxembourg; Email: [email protected]; Tel: +352 260 962 8162European Central Bank, Sonnemannstrasse 20, 60314 Frankfurt am Main, Germany; E-mail: [email protected]; Tel: +49 69 1344 80183Central Bank of Ireland, Dame Street, Dublin 2, Ireland; Email: [email protected]; Tel: +353 1 224 6309
AbstractWe examine the implications of government expenditure that is complementary to private consumption, and government investment that can improve the productivity of private capital in a global DSGE model. We show that government investment can improve an economy’s external competitiveness and stimulate private investment. If governments can finance this investment by reducing consumption that is not complementary to private consumption, then this is ex-ante budget-neutral, provides a small, but persistent stimulus without a deterioration in competitiveness, and leads to lower debt in the medium run. We also examine the cross-border transmission channels of government expenditure shocks in a monetary union when government consumption is complementary to private and public investment is productive. While both assumptions enhance cross-border spillovers, a direct import content is required to generate spillovers similar to those found in the literature
doi:10.2852/25724EU catalogue number DW-AB-15-005-EN-N
1 Introduction
In small open economies (SOEs) belonging to a monetary union, �scal policyis the only standard stabilisation instrument available to national authorities tosmooth business cycle �uctuations. While economists disagree on the size andeven the sign of �scal multipliers, they are closer to an agreement that factorssuch as leakages into saving and imports (Ilzetzki et al., 2013) and the responseof monetary policy to �scal actions (Spilimbergo et al., 2009) matter. Smallereconomies that are more open to trade and countries in which monetary policyo�sets the �scal stimulus will tend to have lower multipliers. In addition, thechoice of �scal instruments used can have important consequences. Expenditurerather than taxation measures are thought to have di�erential e�ects (Freedmanet al., 2009).1 But the type of government expenditure matters as well. Karras(1994) and Fiorito and Kollintzas (2004) argue that government consumption is,at least in part, complementary to private consumption. Similarly, as it has beenargued long ago by Anschauer (1989) and Baxter and King (1993), and later usedby Leeper et al. (2010) and Coenen et al. (2012), government investment canin�uence the productivity of private capital.
Di�erently from D'Auria (2015), Leeper et al. (2010) and Coenen et al.(2012b), we use a multi-country model to examine the e�ects of governmentinvestment that can enhance the productivity of private capital, and governmentconsumption that can be complementary to private consumption. Our analysisconsiders three aspects. First, we focus on a SOE within the European MonetaryUnion (EMU), as the majority of the euro area consists of such countries, andinvestigate the e�ects of the types of government expenditure outlined above insuch a setting.2 We show that if government investment is productive, it can bothstimulate the economy and improve its external competitiveness in the mediumrun.
Second, we argue that this gives rise to a potential trade-o� for governments.We illustrate this by considering an ex-ante budget neutral reorientation ofgovernment expenditure to investment from consumption. Such a measure mayprovide a stimulus without a reduction in external competitiveness both in theshort and medium run, if government consumption is not a strong complement to
1One reason is that increased expenditure has a direct impact on demand, whereas individualsmay save at least some part of a tax cut.
2The cohort of countries of interest is even larger if one considers that many SOEs outsidemonetary unions peg their exchange rate to the currency of a much larger economy. As such,traditional instruments such as the nominal interest and exchange rates do not necessarily reactas desired to macroeconomic developments. These economies are, therefore, in a similiar situationto SOEs in a monetary union with such little weight in area-wide aggregates that nominal interestand exchange rates are e�ectively exogenous.
1
private consumption. This is similar to a �scal devaluation in the sense that it is anex-ante budget neutral measure (e.g. Gomes et al., 2014), but the measures takenare on the expenditure rather than the taxation side, and the channels throughwhich they operate di�er.
Third, we examine the spillovers of government expenditure measures, takenin the remainder of the euro area (REA), on a SOE that is linked with the REAthrough trade and a shared central bank. This di�ers from the literature, ascomplementarities of consumption and productive government investment modifythe cross-border transmission channels of �scal policy.3 We �nd that trade linkagesdo play an important role in the cross-border transmission of �scal policy shocks,but despite the ampli�cation coming from consumption complementarities orproductivity of government investment, a direct import content of governmentspending is required to generate the sizeable spillovers found in some empiricalstudies (e.g. Beetsma and Giuliodori 2011). The main reason is that the interestrate increase in response to the �scal stimulus in most of the euro area negativelya�ects private spending in the economy that does not participate in the �scalexpansion. Nevertheless, countries with stronger trade linkages with the REA aremore a�ected by spillovers. This implies that if there is an increase in publicinvestment in the EMU (e.g., the so-called Juncker Plan) that is not evenlydistributed across countries, then countries with close trade linkages may stillbene�t from spillovers.4
To investigate the issues above, we extend the �scal policy analyticalcapabilities of a global dynamic stochastic general equilibrium (DSGE) model,the EAGLE (Gomes et al. 2012), by introducing complementarity of governmentand private consumption and allowing government investment to be productive,as outlined above. Moreover, we allow for a direct import content of governmentspending, which takes into account that some government purchases in SOEs are onimported goods. To illustrate the e�ect of trade linkages, we calibrate the modelto two countries with very di�erent trade linkages, an important transmissionchannel for �scal policy spillovers (Corsetti et al. 2010). We select Ireland andSlovenia. The former trades primarily with countries outside the EMU, while thelatter trades predominantly within the EMU. One would therefore a priori expect
3To the best of our knowledge, these channels have so far not been explored in a structuralmodel and in the context of a SOE in a monetary union. Some have been investigated separatelyor in the context of a large economy with its own currency (e.g. Leeper et al., 2010; Corsettiand Müller, 2011; Coenen et al., 2012b) and without a focus on cross-border spillovers andthe expenditure policy trade-o�. The complementarity of government consumption and theproductivity of government investment makes our analysis di�erent from those reported in e.g.Kilponen et al. (2015) or Freedman et al. (2009).
4The Juncker Plan calls for an increase in public investment expenditure, with the hope thatit could spur private investment and thus boost euro area economic growth.
2
that shocks originating in the EMU will not have as strong an e�ect on Ireland ason Slovenia. These countries also di�er along a number of structural dimensions,such as the degree of real and nominal rigidities present.5
Our �ndings are in accordance with empirical evidence of the e�ects ofgovernment spending, although papers that explicitly focus on small and veryopen economies within a monetary union are infrequent. Beetsma and Giuliodori(2011) have examined �scal policy spillovers in mostly larger economies in amonetary union and found signi�cant spillovers to their main trading partners.Auerbach and Gorodnichenko (2013) reach a similar �nding. Similarly, papersthat investigate the di�erent impacts of government consumption and investmenttypically uncover di�erential e�ects. Galstyan and Lane (2009) �nd that, for apanel of OECD countries, an increase in government consumption is associatedwith real appreciation, while an increase in government investment may generatereal depreciation. Ilzetzki et al. (2013) �nd that the government investmentmultiplier in developing countries is larger and more persistent and point out thatthe composition of government spending plays a role. A similar point is made byBenetrix and Lane (2013).
We next provide an overview of the baseline EAGLE model, details of theextension to the �scal sector and its calibration. Section 3 discusses the e�ects of agovernment expenditure shocks, with a reorientation from (complementary) publicconsumption to (productive) public investment in Section 4. We then demonstratethe channels through which government expenditure shocks spill over betweeneuro area blocs, and the implications for policy, in Section 5. We follow this witha sensitivity analysis of some of the key model assumptions, and ascertain theirin�uence on the results. The �nal section summarises and concludes.
2 The model
2.1 The EAGLE and its �scal extension
We provide only a brief overview of the main features of the EAGLE here, andrefer the reader to Gomes et al. (2012) for details. The EAGLE is structuredas four regions of the world economy, two of which constitute a monetary union.Each region is modelled as an open New-Keynesian economy, following the Smetsand Wouters (2003) model. The various regions are modelled symmetrically andlinked with each other through bilateral trade relations. This formulation allowsfor a comprehensive treatment of cross-border macroeconomic interdependences
5Note that despite sharing a currency, the reactions of di�erent economies in a monetaryunion to common shocks may di�er widely (see, e.g., Beetsma and Jensen, 2005; Benigno, 2004;Gali and Monacelli, 2008).
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and spillovers. The model has a proportion of non-Ricardian households and anumber of real and nominal rigidities, such as habit formation, adjustment costsfor investment and imports, Calvo-type pricing of �nal goods and wage setting,with partial indexation. Final goods are aggregates of non-tradable and tradable�nal goods, with tradable goods themselves an aggregate of domestically-producedand imported goods.6
Although the EAGLE features a sophisticated tax structure, the governmentexpenditure component is quite stylised and is focused exclusively on home non-tradable consumption goods and transfers to households. The transmissionof government spending shocks to the other sectors of the economy (hometradables and imported goods) therefore depends entirely on the degree ofcomplementarity between these goods. We therefore extend the EAGLE in severalways, signi�cantly altering the responses of the model to government expenditureshocks. First, we explicitly account for an imported component of governmentexpenditure. In a SOE, many of the goods purchased by the government are notproduced domestically, as the economy is not necessarily large enough to produceall of the required goods. Second, we distinguish between government consumptionand investment expenditure. Third, we do not treat all government expenditureas wasteful. We allow for (i) a degree of complementarity between private andgovernment consumption and (ii) government investment that increases the stockof public capital, thereby improving the productivity of the private sector. Thesefeatures open several transmission channels that are especially relevant for veryopen economies, as they a�ect trade �ows and amplify the channels of �scalpolicy spillovers. Although the importance of these transmission channels remainsthe subject of debate, there is plenty of empirical evidence for their existence.7
Nevertheless, we perform an extensive sensitivity analysis in Section 6 to explainthe consequences of alternative values for key parameters controlling these channelsfor our model results.
To permit government spending on imported goods, we assume thatgovernments purchase composite �nal goods. This is produced by �rms thatact under perfect competition and assemble �nal government consumption andinvestment bundles, QGC
t and QGIt , respectively. This is done with a constant
6We use a version of the EAGLE that permits an import content of exports. See Brzoza-Brzezina et al. (2014), for details.
7Karras (1994) and Fiorito and Kollintzas (2004) estimate the relationship between privateand government consumption for a number of countries and generally �nd complementarity.Aschauer (1989) claims that public non-military investment, especially in infrastructure, playsan important role in explaining productivity. While this has also been a matter of debate(Gramlich, 1994), including the exact mechanism at work (Fisher and Turnovsky, 1998), thebelief that public capital can be productive and stimulate private investment seems to persist(see, e.g., German Expert Commission, 2015, or Leeper et al., 2010).
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elasticity of substitution (CES) technology, using tradable goods, TTGCt , and non-tradable goods, NTGCt :8
QGCt =
[ν
1µGCGC
(TTGCt
)µGC−1
µGC + (1− νGC )1
µGC
(NTGCt
)µGC−1
µGC
] µGCµGC
−1
. (1)
Government demand for non-tradable goods is therefore:
NTGCt = (1− νGC )
(PNT,tPGC ,t
)−µGCQGCt , (2)
and analogously for government tradable goods. PNT,t is the price of non-tradablegoods and PGC ,t is the price of �nal government goods. The parameter νGC governsthe share of each type of goods in the bundle and the parameter µGC is theelasticity of substitution between these goods.9 The tradable goods consumedby the government is a bundle of home-produced tradable goods, HTGCt , andimported goods, IMGC
t :
TTGCt =
[ν
1µTGCTGC
(HTGCt
)µTGC−1
µTGC + (1− νTGC )1
µTGC
(IMGC
t
)µTGC−1
µTGC
] µTGCµTGC
−1
. (3)
This implies that government demand for home-produced tradable goods is:
HTGCt = νTGC
(PHT,tPTTGC ,t
)−µTGCTTGCt . (4)
As above, νTGC determines the share of each type of goods in the bundle and µTGCthe elasticity of substitution between them. PHT,t is the price of home tradablegoods and PTTGC ,t is the price of government-consumed tradable goods. Imports ofgovernment consumption goods, IMGC
t , consist of a bundle of (bilateral) importsof tradable goods, IMGC ,CO
t , produced in all other blocs:
IMGCt =
[ ∑CO 6=H
(νH,COMGC
) 1µMGC
(IMGC ,CO
t
)µMGC−1
µMGC
] µMGCµMGC
−1
, (5)
where νH,COMGCsum to 1 and government demand for imports from bloc CO is
8As the equations are identical for the government consumption and investment goods, onlythose for consumption goods are detailed.
9Note that when νGC= 0 we are back to the original EAGLE, where all government
consumption is spent on non-tradable goods.
5
IMGC ,COt = νH,COMGC
(PIM,t
PIMGC ,t
)−µMGC
IMGCt . (6)
The superscript H indicates the home country and the superscript CO the blocfrom which the goods are imported. Again, νH,COMGC
determines the share of goodsfrom each bloc, µMGC is the elasticity of substitution between them, PIM,t isthe price of imported goods and PIMGC ,t is the price of government consumptionimports. Prices are de�ned by equations which correspond to the CES-aggregatedgoods bundles. Prices of government consumption goods, PGC ,t, governmenttradable consumption goods, PTTGC ,t, and government imported consumptiongoods, PIMGC ,t, respectively, are:
PGC ,t =[νGC (PTTGC ,t)
1−µGC + (1− νGC )(PNT,t)1−µGC
] 11−µGC , (7)
PTTGC ,t =[νTGC (PHT,t)
1−µTGC + (1− νTGC )(PIMGC ,t)1−µTGC
] 11−µTGC , (8)
and
PIMGC ,t =
[ ∑CO 6=H
νH,COMGC
(PCOIM,t
)1−µMGC
] 11−µMGC
, (9)
where PCOIM,t is the price of imports from bloc CO. We follow Coenen et al.
(2012b) and introduce government consumption as a partial complement to privateconsumption in the utility function. Utility depends on C̃, which is a CES-aggregate of government and private consumption:
C̃t =
[ν
1µCCESCCES (Ct)
µCCES−1
µCCES + (1− νCCES)1
µCCES (GC,t)µCCES−1
µCCES
] µCCESµCCES−1
. (10)
The share of government consumption goods in the �nal composite goods bundleis determined by νCCES, while µCCES determines the degree of complementarity.Changes in government consumption therefore a�ect optimal private consumptiondecisions directly, as opposed to the indirect wealth e�ect when governmentconsumption is separable. The extended model explicitly accounts for the factthat government investment, GI,t is not wasteful, as in Leeper et al. (2010), andcontributes to public capital, KG,t:
KG,t+1 = (1− δG)KG,t +GI,t, (11)
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where δG is the depreciation rate. KG,t enters the private sector's productionfunction in a non-rivalrous way as follows:
Y ST,t = zT,tK
αGG,t(K
DT,t)
αT (NDT,t)
1−αT − ψT (12)
and analogously for the non-tradable sector.10
Government capital enhances the productivity of private capital in a similarmanner to technological progress. This implies that an increase in governmentcapital will reduce the marginal costs, MCT,t, of the intermediate goods' sector:
MCT,t =1
zT,tKαGG,t(αT )
αT (1− αT )1−αT
(RKt
)αT ((1 + τWf
t )Wt
)1−αT. (13)
The same holds for non-tradable goods.11
2.2 Calibration
Data from the national account statistics are used to adjust key steady-stateratios which represent the underlying structure of the economy.12 The parametersgoverning the trade linkages between the model blocs are based on a mix ofnational accounts data (for the volume of trade) and input-output tables (forthe composition, consumption or investment, of traded goods and the bilateralcomponent of trade). In order to match empirical evidence that the non-tradablesector tends to be more labour intensive, the production function of the tradablesector is permitted a higher share of capital. The remaining parameters in themodel are either based on country-speci�c empirical evidence, where available, orkept consistent with the original model.13 The values of the calibrated parametersand steady-state ratios for both countries are reported in Tables 1 to 3. The main
10Here, Y ST,t is output, zT,t is the level of productivity, αG determines the productivity of
public capital, KDT,t is private capital rented, N
DT,t is labour hired, αT is the capital share in the
tradable sector and ψT represents �xed costs.11The parameter τ
Wf
t accounts for labour taxes paid by �rms, Wt are wages and RKt is the
rental cost of capital.12Given the large �uctuations in the Irish economy in recent years, the elicitation of
appropriate steady-state values is challenging. The data are the long-run (1980-2010) averagesfrom the national account statistics, as gathered from the ESRI model database. This datasetallows for the longest possible horizon to be used, while omitting the large structural changesto the economy that took place prior to this period. The calibration for Slovenia relies onthe national accounts and trade data averages from 2010-2013 to re�ect substantial structuralchanges since the 2008 recession. The key �ndings are robust to calibration using the 2000-2010period.
13The EAGLE uses standard values, prevalent in the literature, for the majority of parameters.See Gomes et al. (2012) for details.
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di�erences between the two economies are in terms of the share of investment andgovernment consumption spending, which are higher in Slovenia, and with respectto the shares of imports in GDP and the structure of imports, such as high import-content of exports in both economies (higher in Ireland). The degree of real andnominal rigidities also di�ers between the two countries. The relative size of thehome bloc is recalibrated to re�ect an SOE's GDP share in the world economy.Previously, the large size of Germany relative to the REA meant that there wassome spillover to the REA from shocks emanating in the home bloc. The smallsize of the recalibrated home bloc means that this channel is e�ectively removed.
The benchmark calibration of parameters that determine the aggregation ofprivate and government consumption expenditure follows Coenen et al. (2012b).The elasticity of substitution between private and government consumption isset to 0.20, and the quasi-share of government consumption expenditure in theaggregator is set to 0.25. This ensures that the observed responses of consumptionto government spending shocks are in line with either country-speci�c or euro-area evidence.14 As such, government and private consumption are strong, butnot perfect, complements, in line with the evidence in Karras (1994) and Fioritoand Kollintzas (2004). We opt for a calibration of government goods witha low elasticity of substitution between non-tradable and tradable goods, butwith relatively high substitution between tradable goods and imported goodsfrom the di�erent blocs. The quasi-share of imported government consumptiongoods is calibrated to achieve a 2 percent of GDP government consumptionthat is spent directly on imports in the steady state. The rationale for thisrelatively small number is that consumption goods purchased by the governmentare to a large extent domestically produced, even in SOEs. This amounts toabout 10 and 15 percent of government consumption in Slovenia and Ireland,respectively. We assume that the share of imported government investmentgoods is higher, as investment goods tend to be very speci�c and less likely tobe produced domestically in a SOE. We therefore calibrate the quasi-share ofimported government investment goods to achieve a 25 percent share of governmentinvestment spending.15 The �scal rule is such that lump-sum taxes are adjusted to
14See Kirchner et al., 2010, Coenen et al., 2012b, and Jemec et al., 201315In calibrating the import content of government consumption and investment expenditure,
we rely on estimates by Corsetti and Müller (2006), in particular on their guideline that homebias is stronger in government expenditure than in private consumption or investment. Weused the values reported in their Table 1 and relied on the approximate relation that governmentexpenditure has about half the import content of private expenditure. For the REA, RW, and theUS we assumed a 10 percent import content of government investment, which is consistent withthe estimate by Corsetti and Müller, who state 12 percent as the upper bound for governmentimports. For the import content of government consumption, we use Corsetti and Müller's lowerbound of 6 percent for the REA and the RW, and the exact value of 5.8 percent for the US.For both Ireland and Slovenia, we set the import content of government consumption to 12
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close the model. The preference parameter for home tradables of the other blocsin the model varies according to the trade matrix of the relevant home bloc, eitherIreland or Slovenia.
Table 1. Steady-state Ratios and Trade Matrix (as % of nominal GDP)
IE SI
Great Ratios
Private consumption 57.9 56.9Private investment 17.6 15.1Target public debt (% of annual GDP) 60.0 60.0Trade linkages
Imports 63.0 69.8Consumption goods 15.0 22.0From REA 5.4 17.6From RW 7.4 4.4From US 2.2 0.1Investment goods 9.2 13.0From REA 3.4 10.1From RW 4.7 2.5From US 1.6 0.3Imports of exports 35.3 31.8From REA 11.3 23.4From RW 15.3 6.9From US 8.7 1.5
percent, the highest value reported by Corsetti and Müller, while for government investment weuse a 25 percent import content. The reason is that both countries are very open, especiallyregarding investment goods. Note that these ratios should be modi�ed for policy simulationswhen governments consider a particular policy action that is known to be more biased towardsforeign or domestic goods.
9
Table 2. Calibration - Households and Firms
IE SI
Households
Subjective discount factor 1.0314 1.03
14
Depreciation rate (private capital) 0.025 0.025Depreciation rate (public capital) 0.025 0.025Int. elasticity of substitution 1.00 1.00Habit formation 0.60 0.60Frisch elasticity of labour (inverse) 2.00 2.00Intermediate goods �rms
Tradable - bias toward capital 0.35 0.42Non-tradable - bias toward capital 0.30 0.30Final cons. goods
Finally, it is assumed that the dynamic adjustment of government consumptionand investment goods is not subject to real rigidities.16 Private investmentadjustment costs are calibrated to replicate the well-known variability ofinvestment over the course of the business cycle (King and Rebelo 1999).
Table 3. Calibration - Real and Nominal Rigidities, Tax Rates
Consumption tax 0.12 0.15Labour income tax 0.16 0.13Capital tax 0.10 0.14SSC paid by �rms 0.09 0.14SSC paid by households 0.07 0.15
3 Expenditure shocks
To illustrate the e�ect of the model extension, we simulate shocks to bothgovernment consumption and investment and use them to explain the transmission
16In new-Keynesian models, investment-adjustment costs are often used to achieve the hump-shaped responses of private investment found in empirical work. As government investment isthe decision of the government, it does not necessarily follow a hump-shaped path.
11
channels of such shocks.17 This is useful to understand the more involved shocksconsidered later, especially in the section discussing �scal policy spillovers.
3.1 E�ect of a government consumption shock
We analyse a 1 percent of ex-ante GDP increase in the government consumptionexpenditure share, GC/Y , detailed in Figure 1. In the benchmark calibrationGC/Y is approximately 20 percent of GDP in Slovenia and about 13 percentin Ireland. Therefore, the shock amounts to a roughly 5 percent increase ingovernment consumption in Slovenia and about 8 percent in Ireland.
The aggregate consumption that enters the utility function is a CES-bundleof government and private consumption (equation 10). We opt for calibrationwhere both types of consumption are su�ciently complementary to obtain apositive co-movement between the two.18 The increase in government consumptionspending stimulates domestic demand through several channels. The standardtransmission channel is the direct impact of government demand on production.19
This stimulates hours worked, as aggregate capital is �xed in the short run.As government consumption expenditure is largely oriented towards domesticallyproduced goods, this results in a reallocation of production and inputs fromtradable to non-tradable goods.
The new transmission channel is due to the complementarity between privateand government consumption, leading to a strong and persistent increase in privateconsumption that further stimulates domestic demand. There is no crowding-outof private consumption as in many models. Because the private consumptionbundle contains a relatively high share of non-tradable goods, the increase inconsumption results in a temporary increase in the production of these goods. The
17The simulations are fully anticipated under perfect foresight using a Newton-type algorithmavailable in DYNARE (Adjemian et al., 2013). All the shocks are for one period, with thepersistence of the shock equal to 0.90 in every case. Shock sizes for government consumptionand investment have been standardised to 1 percent of ex-ante GDP to facilitate comparison. Aslong as the model is (approximately) linear, the e�ects of di�erent shock sizes can be assessedby appropriately rescaling the impulse responses.
18Depending on the exact calibration, the positive co-movement does not necessarily occuron impact, where for calibrations with a high elasticity of substitution between private andgovernment consumption goods, private consumption can initially decline. This is the case ifgovernment and private consumption are less complementary and habit formation is high. Inthis case households desire a smoother path for the consumption bundle as a whole, and so o�setthe sharp initial increase in government consumption with a corresponding decrease in privateconsumption. After a few quarters, however, private consumption increases. See Section 6 for adiscussion of the sensitivity to parameter values.
19Our model allows for the import of government consumption goods. However, the low valuefor the direct import share of government consumption goods implies that they will primarily beproduced domestically.
12
di�erences in the response of private investment in both countries are due to higherprice rigidity of non-tradable goods prices in Slovenia. These imply that after agovernment consumption increase, non-tradable goods become cheaper relative totradable goods, which shifts demand towards non-tradable goods (both becausegovernment spending is largely biased towards domestic goods and because privatedemand shifts toward the relatively less expensive non-tradable goods). Thisleads to greater demand for labour from �rms that wish to satisfy the increaseddemand. Wages increase, which further increases domestic demand, especiallyfrom the non-Ricardian consumers. This increased demand also stimulates privateinvestment, which increases initially.20 Without rigid prices in the non-tradablesector, these e�ects are less pronounced and wages and private investment decrease(as in Ireland). The negative e�ects on home tradables production, due tothe appreciation of the real e�ective exchange rate (as a result of the increasein domestic marginal costs and prices), prevail in the medium run. Exportsdecrease, while imports increase from a combination of the favourable exchangerate movements and high domestic demand for tradable goods.
3.2 E�ect of a government investment shock
To show the e�ect of a change in government investment expenditure, we analysea 1 percent of ex-ante GDP increase in government investment expenditure share,GI/Y , displayed in Figure 2. Unlike the government consumption expenditureshock, government investment expenditure is both much smaller (4 percent ofGDP in our benchmark calibration) and has a very high import content (1 percentof GDP, a quarter of government investment), for the reasons we discussed earlier.This has two direct consequences. First, a 1 percent of (ex-ante) GDP increase ingovernment investment means that government investment increases by roughly 25percent. Second, the high import content causes an immediate increase in importsand a deterioration in the trade balance.
As government investment does not directly a�ect household utility, the onlyimmediate e�ect on consumption is indirectly through the wealth e�ect. Onimpact, output and hours worked increase as the economy has to produce theportion of government investment goods that are not imported. With governmentinvestment goods consisting of both home tradable and non-tradable goods,production increases in both sectors. Resources are diverted away from the privatesector as government investment spending increases. This would typically resultin a decrease in private consumption and investment. The e�ects in our model,however, are more involved. Initially, the increase in consumption by liquidity
20This is particularly the case if investment-adjustment and import-adjustment costs are lower,as is the case for Slovenia.
13
constrained households immune to the wealth e�ect alleviates the decrease inconsumption by Ricardian households. But it is Ricardian households whichincrease consumption in the medium run, as the build-up of productive publiccapital undoes the negative wealth e�ect from higher expected taxes. BecauseRicardians represent a larger share of households, total consumption increases inthe medium run.
The key mechanism is the contribution of the public capital stock to theproductivity of the private sector. The accumulation of public capital reducesprivate sector �rms' marginal costs (see equation 13) and improves competitivenessof the domestic economy in the medium run.21 This results in a reduction ofdomestic in�ation, after the initial demand-driven increase, and in a depreciationof the real e�ective exchange rate, which stimulates production in the domestictradable sector. Improved competitiveness draws in private investment, whichfurther contributes to the increase in output. Due to the higher productivityinduced by the public capital increase, the substitution e�ect prevails over thewealth e�ect and Ricardian households both work more and increase consumption.Note that the model with productive government investment does not need to relyon the existence of non-Ricardian households to generate positive co-movementbetween private consumption and government investment in the medium run.Moreover, the build-up of public capital induces co-movement between privateand government investment and consumption in the medium run.
While the immediate e�ect of government investment worsens the tradebalance, exports increase and the trade balance moves into surplus when publiccapital accumulates.22 This is contrary to the typical belief that governmentspending is in�ationary and results in a deterioration of an economy's competitiveposition. The transmission mechanism is in line with the notion that governmentexpenditure focused on the improvement of infrastructure reduces costs to theprivate sector and that these bene�ts accrue over a longer period of time (e.g.,as claimed by Aschauer, 1989, for non-military public capital). This has oftenbeen used to strengthen the case for greater infrastructure spending. In thecase of Ireland, for instance, Morgenroth (2011) states explicitly that there arepositive e�ects of government infrastructure investment over the short and longrun if additional infrastructure bene�ts the private sector. However, he also notesthat government investment can have no or even negative e�ects if the additionalinfrastructure is not needed. We investigate this in Section 6.
21The e�ects of a government investment increase are persistent because governmentinvestment adds to public capital stock.
22The initial deterioration in the trade balance can be avoided if government investmentpurchase is more oriented towards domestically-produced goods. See Section 6 for details.
14
Figure 1. An increase in government consumption expenditure
0 10 20 30 400
0.5
1
1.5
2
Output
0 10 20 30 40
−0.8−0.6−0.4−0.2
00.20.4
Tradable output
0 10 20 30 400
1
2
3
4
Non−tradable output
0 10 20 30 400
1
2
3
4
Consumption
0 10 20 30 400
2
4
Consumption: Ricardians
0 10 20 30 40
0
1
2
3
4
Consumption: non−Ricardians
0 10 20 30 40
−0.8−0.6−0.4−0.2
00.2
Investment
0 10 20 30 400
0.5
1
Marginal cost: tradables
0 10 20 30 40
0
0.2
0.4
0.6
0.8
Marginal cost: non−tradables
0 10 20 30 40−0.4−0.2
00.20.40.60.8
Inflation
0 10 20 30 40
−0.8
−0.6
−0.4
−0.2
0
0.2Real exchange rate
0 10 20 30 40
−1
−0.5
0
Trade balance
0 10 20 30 40
−0.5
0
0.5
1
Government debt
0 10 20 30 40
−0.2
−0.1
0
0.1
0.2
Real wages
0 10 20 30 400
2
4
6
8
Government consumption
Ireland Slovenia
Notes: Impulse responses to a 1 percent (ex-ante) GDP increase in government consumption
expenditure. All variables are in percentage deviations from the steady state, except trade
balance and government spending (all de�ned as ratios to GDP) and in�ation; the impulse
responses of these variables are in percentage-point deviations.
15
Figure 2. An increase in government investment expenditure
0 10 20 30 400
0.2
0.4
0.6
0.8
Output
0 10 20 30 40
0
0.2
0.4
Tradable output
0 10 20 30 400
0.5
1
1.5
Non−tradable output
0 10 20 30 40
−0.05
0
0.05
Consumption
0 10 20 30 40
−0.05
0
0.05
Consumption: Ricardians
0 10 20 30 40−1
0
1
Consumption: non−Ricardians
0 10 20 30 40
0
0.1
0.2
0.3
Investment
0 10 20 30 40
0
0.2
0.4
Marginal cost: tradables
0 10 20 30 40
0
0.2
0.4
Marginal cost: non−tradables
0 10 20 30 40
−0.1
0
0.1
Inflation
0 10 20 30 40
−0.1
0
0.1
0.2Real exchange rate
0 10 20 30 40
−0.3
−0.2
−0.1
0
Trade balance
0 10 20 30 400
0.5
1
1.5
Government debt
0 10 20 30 40
0
0.05
0.1
Real wages
0 10 20 30 400
10
20
Government investment
Ireland Slovenia
Notes: Impulse responses to a 1 percent (ex-ante) GDP increase in government consumption
expenditure. All variables are in percentage deviations from the steady state, except trade
balance and government spending (all de�ned as ratios to GDP) and in�ation; the impulse
responses of these variables are in percentage-point deviations.
16
4 Government expenditure reorientation
The results of the previous section suggest that governments could improve boththe performance of the economy and its external competitiveness by reducinggovernment consumption and using the proceeds to �nance investment. Wenow perform such an experiment, with the expenditure switch scaled to be onepercent of ex-ante GDP. We do this once assuming government consumption iscomplementary to private consumption, and once without this assumption.23 Theresults are presented in Figure 3.
We �nd that such a re-orientation has negative consequences for output inthe short run, if the link between government and private consumption is strong(depicted in black in Figure 3). The e�ect is stronger for Ireland, becausegovernment consumption has to decrease by more in percentage terms to collect 1percentage point of GDP.24 In the medium run, competitiveness improves due tothe increase in public capital and real exchange rate depreciation persists longer.Output increases after the initial drop and then persists at a higher level than atthe start. Nevertheless, in the longer run, private consumption and investmentincrease, which causes the reduction in the trade balance, while higher wageslead to a small and very gradual erosion of competitiveness. Government debtincreases in the beginning, but decreases in the long run. These results imply thatif a government wishes to stimulate the economy and reduce debt in the shortrun, it should reverse the reorientation of government expenditure, i.e., away frominvestment towards complementary consumption. In the medium run, the cost ofthe stimulus will be a deterioration of the economy's competitiveness.
If the government raises the funds for this investment by reducing thoseconsumption items that are not complementary to private consumption (depictedin grey in Figure 3), all the bene�ts in the medium and long run remain, while thereis a small stimulus to output and consumption in the short run. Moreover, theincrease in public debt is negligible and turns into a small decrease after about fouryears. The trade balance improves in approximately the same period and remainsin surplus for a long time (until public capital depreciates). The real exchange ratedepreciates mildly, but very persistently, despite the increase in wages that is onlymildly smaller than in the previous case. Note that if government consumptionwere a substitute for private consumption, the initial stimulative e�ect would bemuch stronger.
The proposed expenditure reorientation is di�erent from a �scal devaluation,but essentially achieves a similar goal. Such a policy could be used to address
23We keep the import-content of government consumption the same when we shut downcomplementarity.
24Recall that the share of government consumption expenditure in Ireland is only 13 percentof GDP, while it is 20 percent of GDP in Slovenia.
17
the external imbalances that accumulated in the periphery during the �rst decadeof the EMU, without a signi�cant increase in the debt-to-GDP ratio. Note thatgovernments in distress often have the incentive to do the opposite - governmentinvestment is often the �rst to be reduced, as it is the easiest component ofgovernment spending to cut in the short run for political reasons (Gali and Perotti,2003).25
25National accounts data shows that government investment in Ireland at the end of 2012 washalf its peak value, while it was also substantially decreased in Slovenia over the same period.
18
Figure 3. A budget-neutral government expenditure reorientation
0 10 20 30 40
−1.5
−1
−0.5
0
Output
0 10 20 30 40
0
0.5
1
Tradable output
0 10 20 30 40
−3
−2
−1
0
Non−tradable output
0 10 20 30 40
−4
−2
0
Consumption
0 10 20 30 40
−4
−2
0
Consumption: Ricardians
0 10 20 30 40−3
−2
−1
0
Consumption: non−Ricardians
0 10 20 30 40
0
0.5
1Investment
0 10 20 30 40
−0.6
−0.4
−0.2
0
Marginal cost: tradables
0 10 20 30 40−0.6
−0.4
−0.2
0
Marginal cost: non−tradables
0 10 20 30 40
−0.6
−0.4
−0.2
0
0.2
Inflation
0 10 20 30 40
0
0.2
0.4
0.6
0.8Real exchange rate
0 10 20 30 40
0
0.5
1Trade balance
0 10 20 30 40
0
0.5
1
1.5
Government debt
0 10 20 30 40
−0.1
0
0.1
0.2
0.3
Real wages
0 10 20 30 40
−8
−6
−4
−2
0
x 10−3 Nominal interest rate
Ireland Slovenia
Notes: Impulse responses to a 1 percent (ex-ante) GDP increase in government investment
expenditure and simultaneous o�-setting decrease of government consumption expenditure. All
variables are in percentage deviations from the steady state, except trade balance and government
spending (all de�ned as ratios to GDP), in�ation, and nominal interest rate; the impulse responses
of these variables are in percentage-point deviations. The alternative with non-complementary
government consumption is shown in grey.
19
5 Spillovers from government spending shocks
We next illustrate the government expenditure cross-border spillover channelsin our model. To our knowledge, this is the �rst model-based analysis of suchspillovers in a structural model with public spending involving complementarityof government and private consumption and productive government investment,applied to SOEs in a currency union. Given the large number of countries in thiscohort, we feel that this represents an important contribution to the understandingof cross-border spillovers from �scal policy.
A �scal expansion typically causes an endogenous increase of the central bankinterest rate, which reduces private demand and dampens �scal stimulus (Coenenet al., 2012a). A small country that keeps government spending constant, butshares a common monetary policy with a large country or area that engages in�scal stimulus, would be expected to experience mostly negative e�ects. These cancome from trade outside the currency area due to an exchange rate appreciation,trade from within the area as government stimulus crowds out private demand, andfrom the higher area-wide interest rate that reduces domestic demand. However,this seems to be at odds with empirical evidence. For instance, Beetsma andGiuliodori (2011) �nd that �scal expansions in (large) European countries tendto have expansionary e�ects on their main trading partners. Similar �ndings arereported by Corsetti and Müller (2011) for the e�ects of �scal expansions in theU.S. on the euro area and the United Kingdom (i.e. countries not sharing acommon currency).26
Our model can explain such positive spillovers, as an expansionary �scal policyabroad can stimulate foreign private consumption and investment, which a�ectthe domestic economy through higher foreign demand. The purchase of importedgoods by the government can directly a�ect foreign economies. Negative e�ectsarise from an increase in the area-wide interest rate (akin to the �global� interestrate in Corsetti et al., 2010) and an appreciation of the euro. The key issueis whether the positive e�ects through foreign demand are su�ciently strongto dominate the negative e�ects.27 We investigate the strength of spillovers byconsidering an expansionary �scal policy in the REA and analyse the e�ectson Ireland and Slovenia, where �scal policy is assumed to remain unchanged.28
26They �nd that U.S. imports tend to remain constant after the �scal expansion, while U.S.exports increase. This indicates that a �scal expansion in the U.S. does not lead to higher exportsfrom the euro area to the U.S.
27Note that we do not use a zero-lower-bound setting as Coenen et al. (2012a), because wewish to establish whether the strength of transmission channels induced by complementarityof government consumption or productivity of government investment can explain empiricalevidence. Shutting down the interest rate channel would obviously favour such conclusions.
28This could, for example, represent a situation where budgetary pressures in an economy donot permit an expansion, or where there is no productive investments which can be made.
20
Given the two countries' di�ering trade linkages, it is a priori expected that shocksoriginating in the REA will have a weaker e�ect on Ireland.
5.1 Spillovers from a government consumption shock
The e�ect of a government consumption increase by 1 percent of ex-ante GDPin the REA is shown in Figure 4. Although output increases in the shortrun, the medium-run responses are contractionary. Direct imports for REAgovernment consumption increase the home country's trade balance and output.The contemporaneous increase in foreign private consumption increases exportsof goods for consumption abroad (see bottom right panel of Figure 4), providingsome ampli�cation in countries linked through trade in consumption goods. Whilethe intensity of the government spending impulse is the same in both countries, theampli�cation through exports of private goods is, as expected, lower in Ireland dueto their lower trade with the REA. The transmission of foreign demand impulsesdepends mainly on two features.
First, higher price rigidity in the non-tradable sector in Slovenia makes thesegoods relatively cheaper than tradable goods. This leads to a shift in domesticdemand towards non-tradable goods, supported by roughly unchanged real wagesin the short run.29 Strong foreign demand for tradable goods increases the demandfor labour in this sector, but labour does not shift between sectors in Slovenia asmuch as in Ireland. As a result, marginal costs in Slovenia increase by a largeramount in both sectors, and more persistently. Real wages still decrease slightlybecause of higher in�ation, but much less than in Ireland. The positive e�ects ofstrong foreign demand on output in Slovenia are slightly ampli�ed by the increasein private consumption, but this is dwarfed by the decrease in investment, drivenby low investment adjustment costs. The greater openness of Slovenia towards theREA shows in the somewhat more persistent trade balance, which is supportedby the path of private consumption in the REA, but also by the drop of domesticinvestment with high import content.
Second, Ireland's trade balance increases to a larger extent because of thelarger steady-state current account surplus. Given the approximately same percentdi�erence between the increase in exports and in imports in both countries, thisresults in a stronger contribution of the trade balance to GDP.30 In both countriesexports to non-euro blocs decrease due to the exchange rate appreciation (not
29Rigid prices in the non-tradable sector imply that the foreign stimulus on the domestictradable sector spills over by means of higher demand for non-tradable goods, putting upwardpressure on wages. In Ireland the relative price e�ect is lower and labour reallocates from non-tradable to tradable sector and causes less upward pressure on wages.
30Because of exports' high import content, both tend to move together after foreign demandshocks.
21
shown). Over the medium term, a drop in foreign demand from the euro area andpersistently higher interest rates cause a recession.
5.2 Spillovers from government investment
The e�ects of a government investment increase by 1 percent of ex-ante GDP inthe REA are shown in Figure 5. The increase in area-wide interest rate means thatprivate consumption and investment in the REA only increase after a substantiallag of 15 - 20 quarters, and so the contribution of non-government components toexport demand is negative until very far in the future. The strong initial increasein exports and (tradable) output of Ireland and Slovenia is entirely the result ofthe direct import of government investment goods.31
Wages increase due to higher labour demand, but also due to higher domesticconsumption. This is due to stronger and more persistent reduction in debt, whichinduces Ricardian consumers to consume more. Essentially, consumers spread theinitial burst in foreign demand over a longer period, by working less and consumingmore in the medium run. Given higher productivity of a major trading partnerin the medium run due to the larger productive public capital stock, there appearto be no long-lasting adverse consequences in the sense that both consumptionand private investment increase in the medium run, which is the main factor thatdrives the negative trade balance over the longer horizon.
5.3 Policy implications from spillovers
Our results imply that the stronger and more positive the e�ect of �scal expansionon private consumption and investment in the region engaged in the stimulus,and the greater the import content of these goods, the more bene�cial is thespillover to non-expanding countries that have close linkages to the expandingregion. In this respect, policies such as, for example, subsidies for the replacementof old cars in Germany were bene�cial for regions that supply car parts to Germanmanufacturers or manufacture cars sold in Germany.32 Obviously, if governmentexpenditure itself has a high import component, then this has an immediate andstrong cross-border e�ect. Policies such as the so-called Juncker Plan, while notmeant as a cyclical stabilisation tool, may have positive e�ects even on countriesthat would not bene�t directly (i.e. do not have infrastructure projects), but the
31The initial output increase is larger than for government consumption increase in the REAbecause both are standardised to be a one percentage point of ex-ante GDP. Because governmentinvestment is smaller than consumption, the increase has to be larger, hence the stronger e�ect.Note, however, that the increase in the area-wide interest rate is also higher, and hence thedampening e�ect is stronger.
32We are grateful to Gabriel Fagan for pointing this out.
22
condition is that they either produce goods that will be used in such projects, orthat the plan will induce immediate increase in private consumption or investmentthat will generate spillovers.
Again, the interest rate and exchange rate channels from a �scal expansion ina large region of the euro area tend to be very strong. It is thus very di�cult todominate these e�ects with trade linkages, as a positive spillover hinges on a largeshare of direct imports of domestic goods by foreign households or governments.
23
Figure 4. A government consumption increase in the REA
0 10 20 30 40−0.2
0
0.2
Output
0 10 20 30 40
−0.2
0
0.2
0.4
0.6
Tradable output
0 10 20 30 40−0.1
−0.05
0
0.05
Non−tradable output
0 10 20 30 40
−0.04
−0.02
0
0.02
0.04Consumption
0 10 20 30 40
−0.06
−0.04
−0.02
0
0.02
Consumption: Ricardians
0 10 20 30 40−0.2
0
0.2
0.4
0.6
0.8
Consumption: non−Ricardians
0 10 20 30 40
−1
−0.5
0Investment
0 10 20 30 400
0.05
0.1
0.15
0.2
Marginal cost: tradables
0 10 20 30 400
0.05
0.1
0.15
Marginal cost: non−tradables
0 10 20 30 400
0.1
0.2
0.3
Inflation
0 10 20 30 40
−0.2
−0.1
0
Real exchange rate
0 10 20 30 40
0
0.1
0.2
0.3
Trade balance
0 10 20 30 40
−0.2
−0.1
0
0.1Government debt
0 10 20 30 40
−0.08
−0.06
−0.04
−0.02
0
Real wages
0 10 20 30 40−0.5
0
0.5
Exports to REA for private use
Ireland Slovenia
Notes: Impulse responses to a 1 percent (ex-ante) GDP increase in government consumption
expenditure. All variables are in percentage deviations from the steady state, except trade
balance and government spending (all de�ned as ratios to GDP), in�ation, and nominal interest
rate; the impulse responses of these variables are in percentage-point deviations.
24
Figure 5. A government investment increase in the REA
0 10 20 30 40
0
0.2
0.4
0.6Output
0 10 20 30 40
0
0.5
1
Tradable output
0 10 20 30 40
0
0.05
0.1
Non−tradable output
0 10 20 30 400
0.05
0.1
Consumption
0 10 20 30 400
0.05
0.1
Consumption: Ricardians
0 10 20 30 400
0.5
1
Consumption: non−Ricardians
0 10 20 30 40
−0.4
−0.2
0
0.2
Investment
0 10 20 30 400
0.1
0.2
0.3
Marginal cost: tradables
0 10 20 30 400
0.1
0.2
Marginal cost: non−tradables
0 10 20 30 40
0
0.1
0.2
0.3
Inflation
0 10 20 30 40
−0.2
−0.15
−0.1
−0.05
0
Real exchange rate
0 10 20 30 40
0
0.2
0.4
Trade balance
0 10 20 30 40
−0.3
−0.2
−0.1
0
Government debt
0 10 20 30 40
0
0.05
0.1
Real wages
0 10 20 30 40
−0.2
−0.1
0
Ex. to REA for private use
Ireland Slovenia
Notes: Impulse responses to a 1 percent (ex-ante) GDP increase in government investment
expenditure. All variables are in percentage deviations from the steady state, except trade
balance and government spending (all de�ned as ratios to GDP), in�ation, and nominal interest
rate; the impulse responses of these variables are in percentage-point deviations.
25
Nevertheless, our results imply that if a SOE has an important small(er)trading partner, such that its �scal policies do not a�ect the area-wide interestand exchange rates, then trade channels will be more potent and spillovers from�scal expansion larger. The same would hold if monetary policy would hold thearea-wide interest rate constant for a period.33
6 Sensitivity Analysis
To illustrate the impact of our modelling and calibration choices on the modeltransmission mechanisms, we investigate the changes in three key parameters.These are the complementarity between private and government consumption,µCCES, productivity of public investment, αG, and the scale of direct imports ingovernment investment expenditure, νTG. Results are shown in Figures 6 to 8,where the benchmark case is shown in black and the alternative in grey. Theresponses for Ireland are shown with solid lines and for Slovenia with dashed.
Public and private consumption complementarity. To investigate thee�ect of complementarity between public and private consumption, we simulatethe same increase in public consumption as in the benchmark case, but withconsumption complementarity shut down. Not surprisingly, the e�ects ofgovernment stimulus on output are approximately halved and more short-lived, asshown in the left column of Figure 6. The reason is that consumption of Ricardianhouseholds does not increase following an increase of government consumption,but is crowded out instead.34 This results in a substantially smaller domesticstimulus, which is re�ected in lower real exchange appreciation and lower tradede�cit. This implies that a �scal stimulus should be focused on those publicconsumption goods that are complementary to private consumption.35 Publicsaving, on the other hand, should be focused on government consumption goodsthat are close substitutes for private goods.
Productivity of public capital. We investigate sensitivity by considering anincrease in public investment when the productivity of public investment is at the
33See Coenen et al., 2012a, for an analysis in large blocs that are not currency unions.34Consumption of non-Ricardian households still increases, but this e�ect is dominated by
Ricardian households who represent 75 percent of all households in the model. Note that wedo not make government consumption a substitute for private consumption; if we did, privateconsumption would drop sharply on impact and undo the entire �scal stimulus.
35Karras (1994) conjectures that transportation is such a good. Fiorito and Kollintzas (2004)claim that these are goods such as health, education, and public services, and provide empiricalevidence for complementarity in 12 European economies.
26
higher range of plausible values, 0.10, as in Baxter and King (1993) and Leeper etal. (2010).36 Results are displayed in the middle column of Figure 6. There is littledi�erence in the very short run, because an increase in government investment onlyincreases aggregate demand for (investment) goods. But once the public capitalstock accumulates, di�erences in its productivity begin to play a role. Privateinvestment begins to increase immediately and much more strongly than in thebenchmark case, in anticipation of the accumulation of productive public capital.Improved productivity in the medium run results in substantial depreciation ofthe real e�ective exchange rate and improves external competitiveness. While thetrade surplus is positive in the longer run, the short-run de�cit remains, which islargely due to the increase in domestic private investment with substantial importcomponent. Positive co-movement between private and public investment canonly occur if public capital substantially enhances the productivity of privatecapital. Anecdotal evidence that public investment attracts private investment(as advocated by e.g. German Expert Commission (2015)) should be treated withcaution, as it holds only if the productivity of public investment is high.37 Thesame holds for competitiveness gains.
Import content of government investment. In our baseline calibration,the share of government consumption expenditure that is directly imported is10 percent, while the import content of government investment is 25 percent.We analyse the impact of an increase in government investment when importcontent of government investment is the same as that of government consumption,10 percent (or 0.004 percent of GDP). The right column of Figure 6 details theresults. The di�erences are not very large and limited only to the short-run. Withlower government imports, the trade balance deteriorates by less on impact, butthis is dampened to some extent because the stimulus to the domestic economyis stronger, which results in a sharper exchange rate appreciation and a loss ofcompetitiveness. Importantly, this is undone in the medium run. The reasonis that the medium-run bene�ts of increased public investment depend only onthe stock of public capital, and not on the origin of this capital (whether it wasimported or produced at home).38
36Note that this is not excessive. Ascahuer (1989) estimates productivity of public capital at0.24 for infrastructure, 0.04 for other buildings, and 0.06 for hospitals. Baxter and King (1993)examine values ranging from 0 to 0.4 in a general equilibrium model.
37The Report of the Commission of German experts for instance claims explicitly on p. 5that "The Expert Commission stresses that public investment and private investment are highlycomplementary."
38Similar e�ects would be observed for the direct import of government consumption, exceptfor the positive medium-run e�ects. The results are available upon request.
27
Figure 6. Sensitivity to key parameters
0 10 20 30 400
0.5
1
1.5
2
Complementarity of G C
Out
put
0 10 20 30 400
0.2
0.4
0.6
0.8
Productivity of G I
Out
put
0 10 20 30 400
0.5
1
Import−content of G I
Out
put
0 10 20 30 400
2
4
Ric
ardi
an C
0 10 20 30 40
0
0.2
0.4
Inve
stm
ent
0 10 20 30 40
−0.05
0
0.05
Con
sum
ptio
n
0 10 20 30 40
−0.8−0.6−0.4−0.2
00.2
Inve
stm
ent
0 10 20 30 40
0
0.2
0.4
0.6
MC
− tr
adab
le
0 10 20 30 40
0
0.1
0.2
0.3
0.4
Inve
stm
ent
0 10 20 30 40
−0.8
−0.6
−0.4
−0.2
0
0.2
Rea
l ER
0 10 20 30 40
−0.1
0
0.1
0.2
0.3
Rea
l ER
0 10 20 30 40
−0.2
−0.1
0
0.1
0.2
Rea
l ER
0 10 20 30 40
−1
−0.5
0
Tra
de b
alan
ce
0 10 20 30 40
−0.3
−0.2
−0.1
0
Tra
de b
alan
ce
0 10 20 30 40
−0.3
−0.2
−0.1
0
Tra
de b
alan
ce
Ireland Slovenia
Notes: Impulse responses to a 1 percent (ex-ante) GDP increase in government consumption
or investment expenditure. All variables are in percentage deviations from the steady state,
except for the trade balance, which is de�ned as a ratio to GDP and should be interpreted as
percentage-point deviation.
28
6.1 Complementarity and cross-border spillovers.
The elimination of complementarity between government and private consumptiona�ects cross-border spillovers through several channels, as shown in Figure 7.There is still a strong initial expansion of output due to direct government demandfrom abroad. This is however not supplemented by private consumption demand,which results in a lower trade balance, especially in Slovenia, which trades mainlywith the REA.39 There is a much less persistent increase in marginal costs dueto a less persistent increase in return on capital, caused by lower investment-adjustment costs. This leads to a lower increase in domestic in�ation. However, asdirect foreign demand for government imports increases the real interest rate, thereduction in consumption is ampli�ed and causes non-tradable output to decrease.Note that except for the initial push from direct foreign government purchases,these e�ects are absent in Ireland, as it does not trade with the REA as muchas Slovenia.40 Eliminating complementarity induces the area-wide interest rateto increase by much less, resulting in a substantially lower decline of domesticinvestment in both countries. This explains why output is not even lower whendemand stimulus from abroad is absent. Moreover, this is the main reason whyoutput in Ireland is relatively close to that of Slovenia despite di�erent tradelinkages. Domestic investment in Ireland does not decrease by as much as inSlovenia, which partly compensates the missing foreign demand due to lower tradeintensity with the REA.
39In particular, the hump-shaped part of the trade balance response after the initial increaseis missing, because there is no increase in REA consumption. The response of tradable outputafter one year is for instance by about a third lower in Slovenia and only about 10 percent lowerin Ireland.
40Marginal costs, the real e�ective exchange rate, and consumption are almost the same inIreland in both scenarios.
29
Figure 7. Complementarity of government consumption and spillovers
0 10 20 30 40−0.2
0
0.2
Output
0 10 20 30 40
−0.2
0
0.2
0.4
0.6
Tradable output
0 10 20 30 40−0.1
−0.05
0
0.05
Non−tradable output
0 10 20 30 40−0.15
−0.1
−0.05
0
0.05
Consumption
0 10 20 30 40
−0.15
−0.1
−0.05
0
0.05
Consumption: Ricardians
0 10 20 30 40−0.2
0
0.2
0.4
0.6
0.8
Consumption: non−Ricardians
0 10 20 30 40
−1
−0.5
0
Investment
0 10 20 30 400
0.05
0.1
0.15
0.2
Marginal cost: tradables
0 10 20 30 400
0.05
0.1
0.15
Marginal cost: non−tradables
0 10 20 30 400
0.1
0.2
0.3
Inflation
0 10 20 30 40
−0.2
−0.1
0
Real exchange rate
0 10 20 30 40
0
0.1
0.2
0.3
Trade balance
0 10 20 30 40
−0.2
−0.1
0
0.1Government debt
0 10 20 30 40
−0.08
−0.06
−0.04
−0.02
0
Real wages
0 10 20 30 400
0.05
0.1Nominal interest rate
Ireland Slovenia
Notes: Impulse responses to a 1 percent (ex-ante) GDP increase in government consumption
expenditure in the REA. All variables are in percentage deviations from the steady state,
except trade balance and government spending (all de�ned as ratios to GDP) and in�ation;
the impulse responses of these variables are in percentage-point deviations. The alternative with
non-complementary government consumption is shown in grey.
30
6.2 Productivity of investment and cross-border spillovers.
To analyse the in�uence of public capital productivity on spillovers, we set αG inthe REA to 0.10 and increase government investment by 1 percentage point of ex-ante GDP with. The result in grey is shown together with the benchmark in blackin Figure 8. The most striking result is that higher public capital productivityin the REA has practically no e�ect on Ireland. The reason is that, �rst, thehigher productivity of public investment in the REA does not alter the path of thearea-wide interest rate substantially, and second, Ireland does not trade with theREA as much as Slovenia. The latter experiences a higher increase in domesticconsumption, driven by larger reduction in public debt and higher wages, and hencehigher non-tradable output. Note that competitiveness increases if investment inthe REA is more productive. The reason is that higher investment productivitystimulates private consumption and private investment in the REA, both resultingin higher prices in the REA. This improves the competitiveness of countries thattrade with such an area, as is the case for Slovenia.
31
Figure 8. Productivity of public investment and spillovers
0 10 20 30 40
0
0.2
0.4
0.6
Output
0 10 20 30 40
0
0.5
1
Tradable output
0 10 20 30 40
0
0.05
0.1
0.15
Non−tradable output
0 10 20 30 400
0.05
0.1
0.15
0.2Consumption
0 10 20 30 400
0.05
0.1
0.15
Consumption: Ricardians
0 10 20 30 400
0.5
1
Consumption: non−Ricardians
0 10 20 30 40
−0.4
−0.2
0
0.2
0.4
Investment
0 10 20 30 400
0.1
0.2
0.3
0.4
Marginal cost: tradables
0 10 20 30 400
0.1
0.2
Marginal cost: non−tradables
0 10 20 30 40
0
0.1
0.2
0.3
0.4Inflation
0 10 20 30 40
−0.2
−0.1
0
0.1Real exchange rate
0 10 20 30 40
0
0.2
0.4
0.6
Trade balance
0 10 20 30 40−0.4
−0.3
−0.2
−0.1
0
Government debt
0 10 20 30 40
0
0.05
0.1
0.15
0.2Real wages
0 10 20 30 40
0
0.02
0.04
Nominal interest rate
Ireland Slovenia
Notes: Impulse responses to a 1 percent (ex-ante) GDP increase in government consumption
expenditure in the REA. All variables are in percentage deviations from the steady state,
except trade balance and government spending (all de�ned as ratios to GDP) and in�ation;
the impulse responses of these variables are in percentage-point deviations. The alternative with
more productive government investment is shown in grey.
32
7 Conclusions
This paper examines the impact of government spending in a SOE in a monetaryunion. Our key �ndings can be summarised as follows. First, governmentinvestment expenditure has a persistent positive e�ect on the domestic economy,even if a large portion of government investment is imported, provided thatpublic capital is productive. Productive public capital lowers the marginalcosts of �rms in the medium run, which causes a real e�ective exchange ratedepreciation and stimulates exports, which is a particularly strong channel in aSOE. Productive public capital also draws in (after a delay) private investment.The result is that after a possible initial negative reaction, private investment,private consumption and output all increase. Second, with a su�cient degreeof complementarity between government and private consumption, governmentconsumption expenditure can have strong e�ects on private consumption and henceoutput. These e�ects however, tend to be relatively short-lived and eventually leadto a loss of external competitiveness. Third, a high import content of governmentexpenditure has direct negative e�ects on government spending multipliers.
We �nd that governments could provide a moderate stimulus to the economywithout reducing its external competitiveness if they �nance public investment,conditional on its being productive, with a reduction of government consumptionthat is wasteful or a substitute to private consumption. This operation is ex-antebudget-neutral and leads to a reduction in public debt and an improved currentaccount in the medium run.
A high import content of government expenditure means that part of thegovernment spending increase ends as a stimulus to foreign exporters. The stimulusfrom a foreign government expenditure does not come with an increase in expectedfuture taxes, but it does bring higher interest rates for the entire currency area,which counters the positive e�ects of the stimulus. Our results show that �scalstimulus in one region can generate positive spillovers despite the area-wide interestrate increase, if it generates a su�cient increase in private spending and henceimports. The e�ects will obviously be stronger and more persistent if monetarypolicy keeps interest rates constant.
The notion of government investment stimulating the economy is an underlyingpremise of the so-called Juncker Plan, an idea to revive growth in Europe andstimulate private investment by investing in infrastructure. We show that thismay indeed attract private investment, but the condition is that the governmentundertakes investment that increases the productivity of the private sector. If thisis not the case, private investment is crowded out.
33
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