Working Paper Series. Policy spillovers and synergies in a monetary union. No 1942 / August Óscar Arce, Samuel Hurtado and Carlos Thomas

Transcription

1 Working Paper Series Óscar Arce, Samuel Hurado and Carlos Thomas Policy spillovers and synergies in a moneary union Task force on low inflaion (LIFT) No 1942 / Augus 2016 Noe: This Working Paper should no be repored as represening he views of he European Cenral Bank (ECB). The views expressed are hose of he auhors and do no necessarily reflec hose of he ECB.

2 Absrac We provide a general equilibrium framework for analyzing he effecs of supply and demand side policies, and he poenial synergies beween hem, in an asymmeric moneary union ha faces a liquidiy rap and a slow delever-aging process in is periphery. We find ha he join implemenaion of pro-compeiion srucural reforms in he periphery, a fiscal expansion in he core, and forward guidance abou he fuure pah of nominal ineres raes produces posiive synergies beween he hree policies: forward guidance re-inforces he expansionary effecs of counry-specific policies, and he laer in urn improve he effeciveness of forward guidance. Our resuls provide a case for complemening curren unconvenional moneary simuli in he euro area wih naional effors on he srucural reform and fiscal frons. Keywords: moneary union, deleveraging, zero lower bound, srucural reforms, synergies JEL Classificaion: E44, E63, D42 ECB Working Paper 1942, Augus

3 Non-Technical Summary: The global financial crisis iniiaed in 2008 riggered a deep and prolonged seback for aggregae demand in all major indusrialized economies, paving he way for persisenly low inflaion raes. In he euro area, he crisis has also revealed forcefully he imbalances and efficiency gaps across is member saes. In mos of he so-called periphery, he combinaion of high indebedness, deleveraging and widespread dysfuncionaliies in labor and produc markes is feeding fears of a long-lasing scenario of weak and fragile growh, wih adverse consequences for he enire union. Agains his conex, many voices are calling for a simulaneous implemenaion of supply and demand side policies wihin he euro area. On he supply side, he removal of inefficiencies and he enhancemen of marke compeiion are invoked as he only lever available o he periphery so as o regain is compeiiveness vis-à-vis he res of he euro area. On he demand side, given ha he periphery lacks sufficien fiscal space o simulae domesic demand and ha he European Cenral Bank is already consrained by he zero lower bound (ZLB), he aenion has shifed owards he role of non-sandard moneary policies and he possibiliy of expansionary fiscal measures in he `core'. Moreover, he policy debae has progressively moved owards wo closely inerlinked areas: firs, he poenial for policyinduced spillovers across counries wihin he euro area and, second, he likely complemenariies or synergies beween non-sandard moneary policy, srucural reforms, and fiscal policy. We provide a general equilibrium framework for analyzing he effecs of supply and demand side policies, he associaed cross-counry spillovers, and he poenial synergies beween such policies, in an asymmeric moneary union ha faces a liquidiy rap and a slow deleveraging process in is 'periphery'. In erms of spillovers, we find ha he effecs of naional policies on oher counries depend crucially on wheher moneary policy is consrained by he ZLB. Thus, deflaionary srucural reforms in he periphery end o creae (small) conracionary effecs in he 'core' when he moneary auhoriy canno accommodae such a deflaionary pressure. On he conrary, a fiscal expansion in he core may benefi he periphery provided he moneary auhoriy is suck a he ZLB and hence does no reac o he resuling inflaionary pressure. As regards he synergies across hese policies, we find poenially sizable shor-run economic gains from heir join implemenaion. Thus, forward-guidance reinforces he expansionary effecs of counry-specific policies, and he laer in urn improve he effeciveness of forward guidance. Two prominen channels hrough which hese synergies ake places are he following. Firs, forward guidance lowers long-run real ineres raes and hence increases he presen-discouned value of he fuure oupu and consumpion gains produced by naional simulus policies, hus fosering invesmen and consumpion already in he shor-run. Second, under our implemenaion of forward guidance, he laer reinforces he expansionary effecs of demand-side policy simuli, such as a fiscal expansion, by avoiding he upward shif in he nominal ineres rae pah ha such simuli would oherwise produce. ECB Working Paper 1942, Augus

4 1 Inroducion The global financial crisis iniiaed in 2008 riggered a deep and prolonged seback for aggregae demand in all major indusrialized economies, paving he way for persisenly low inflaion raes. In he euro area, he crisis has also revealed forcefully he imbalances and effi ciency gaps across is member saes. In mos of he so-called periphery, he combinaion of high indebedness, deleveraging and widespread dysfuncionaliies in labor and produc markes is feeding fears of a long-lasing scenario of weak and fragile growh, wih adverse consequences for he enire union. Agains his conex, many voices are calling for a simulaneous implemenaion of supply and demand side policies wihin he euro area. On he supply side, he removal of ineffi ciencies and he enhancemen of marke compeiion are invoked as he only lever available o he periphery so as o regain is compeiiveness vis-à-vis he res of he euro area. On he demand side, given ha he periphery lacks suffi cien fiscal space o simulae domesic demand and ha he European Cenral Bank is already consrained by he zero lower bound (ZLB), he aenion has shifed owards he role of non-sandard moneary policies and he possibiliy of expansionary fiscal measures in he core. Moreover, he policy debae has progressively moved owards wo closely inerlinked areas: firs, he poenial for policy-induced spillovers across counries wihin euro area and, second, he likely complemenariies or synergies beween non-sandard moneary policy, srucural reforms, and fiscal policy. 1 The issue of fiscal spillovers in a moneary union has recenly been he subjec of formal quaniaive analysis, e.g. by Erceg and Lindé (2013) and Blanchard, Erceg and Lindé (2014). However, relaively less is known abou cross-counry spillovers induced by he adopion of srucural reforms in one par of he union. Criically, 1 See, for example, Draghi (2014, 2015, 2016), Obsfeld (2016), European Commission (2014) and IMF (2014). ECB Working Paper 1942, Augus

5 even less is known abou he poenial synergies beween such srucural reforms, fiscal expansion in he res of he union, and union-wide unconvenional moneary policies a he ZLB. In his paper, we address hese issues in he conex of a model of an asymmeric wo-counry ( core and periphery ) moneary union. In boh counries, households and firms borrow long-erm subjec o collaeral consrains. We consruc a baseline scenario aimed a capuring key feaures of he curren macroeconomic landscape in he euro area. Firs, he periphery is assumed o be hi by an adverse financial shock ha ighens he collaeral requiremens on he loans o households and firms. This shock, combined wih collaeral consrains and long-run deb, gives rise o a proraced and cosly process of deleveraging in he periphery wih implicaions for he moneary union as a whole. Second, a union-wide demand shock causes a reducion in union-wide inflaion ha is large enough o drive he moneary auhoriy s nominal ineres rae owards is ZLB. Boh shocks combine o produce a long-lasing recession and persisenly low inflaion in he currency union as a whole. Agains his background, we analyze he effecs of wo ypes of counry-specific macroeconomic policies: srucural reforms in he periphery (consising of reducions in price and wage-seers monopolisic rens), and a emporary increase in governmen spending in he core. We show ha he cross-counry spillovers of such policies depend criically on he incidence of he ZLB. Ouside of he ZLB, srucural reforms have a posiive oupu effec on he periphery already on impac, bu produce a sligh posiive impac on he core oo, hanks o he moneary accommodaion of he ensuing disinflaionary pressures. A governmen expendiure expansion in he core, on he conrary, aggravaes he recession in he periphery, as he cenral bank ighens is policy rae in response o he inflaionary pressures coming from he core. By conras, in a liquidiy rap he sign of he previous cross-counry spillovers are reversed. Firs, reforms in he periphery, which remain expansionary for he laer alhough less so, produce a negaive (hough relaively small) effec on he core. Similarly, absen he previously discussed moneary ighening, a fiscal expansion in he core produces sizeable posiive spillovers for he periphery. 2 2 This las resul coincides wih he one in Erceg and Lindé (2013) or Blanchard, Erceg and Lindé ECB Working Paper 1942, Augus

6 We nex consider he possibiliy ha he moneary auhoriy follows a forward guidance policy wih he aim of raising area-wide GDP and inflaion while in he liquidiy rap. In paricular, we analyze he case in which he cenral bank can credibly commi o keeping he ineres rae a zero for wo more quarers han wha is sandard rule would dicae. Such a policy is found o have posiive effecs, of a similar magniude, in he oupu of boh regions. This las resul is remarkable because, during he deleveraging phase (which lass longer han he liquidiy rap in our simulaions), he credi flow in he periphery is frozen, such ha credi-consrained agens are no exposed o he usual ineremporal consumpion subsiuion channel of forward guidance. Thus, in our seup he effeciveness of forward guidance on he periphery seems o be more relaed o oher ransmission channels, such as he coreperiphery rade channel and ne worh effecs on he balance-shees of deleveraging agens. We hen quanify he synergies beween he hree policies, an exercise for which our nonlinear model (and our fully nonlinear soluion mehod) is well suied. We find ha he shor-run expansionary effecs of naional simulus measures (reforms in he Periphery and fiscal expansion in he Core) increases by a sizable amoun when in parallel he moneary auhoriy implemens a policy of forward guidance. Conversely, he expansionary impac of forward guidance is largely enhanced when a he same ime each counry implemens is respecive policy package. Imporanly, hese posiive synergies ake place boh for he moneary union as a whole and for each individual counry. We sress wo prominen channels for hese synergies. On he one hand, counryspecific policies produce expansionary effecs ha run beyond he shor erm, especially in he case of srucural reforms ha may deploy permanen effecs on oupu. Thus, he forward-guidance-driven reducion in long-run real ineres raes raises he presen-discouned value of such gains, via income and ne worh effecs, wih he resuling posiive effec on curren consumpion and invesmen (discouning effec). On he oher hand, counry-specific policies affec he endogenous pah of he nominal ineres rae when he laer follows a sandard ZLB-consrained Taylor rule, (2014). ECB Working Paper 1942, Augus

7 including he dae a which he nominal rae exis he ZLB (he lif-off dae). For insance, an inflaionary fiscal expansion ends o shoren he duraion of he ZLB, which moderaes is posiive impac; 3 hus, a simulaneous commimen o keeping ineres raes a zero for longer eliminaes such moderaing effec and augmens he expansionary impac of he fiscal simulus. This posiive lif-off effec changes sign in he case of deflaionary srucural reforms. Our analysis hus sresses he imporance of joinly implemening forward guidance and boh supply- and demand-side counry-specific policies, as i is his package ha brings ogeher he discouning and (posiive) lif-off effecs and hus maximizes he posiive synergies. 4 Relaed lieraure. By analyzing he join implemenaion of demand and supply side policies, we conribue o a long-sanding radiion in macroeconomics, wih early conribuions by Blanchard e al. (1985), Buier (1987) and Bean (1994), among ohers. Our paper revisis his opic in he conex of a quaniaive modern dynamic general equilibrium (DGE) framework. More specifically, our paper conribues o he lieraure on he evaluaion of macroeconomic policies in a currency union in he conex of quaniaive DGE models. Our analysis shares several hemes wih previous conribuions, such as he effecs of naional policies (fiscal expansion/consolidaion, srucural reforms, ec.) and heir cross-counry spillovers, he role of he ZLB in shaping he impac of such policies, and he effecs of forward guidance by he moneary auhoriies in he face of a binding ZLB. Relaive o his lieraure, which we summarize nex, one imporan conribuion is ha we analyze quaniaively he synergies beween naional policies and (non-sandard) union-wide moneary measures, in sync wih recen policy debaes in he euro area. A recen lieraure sudies he effecs of counry-specific fiscal policies, and he associaed cross-counry spillovers, in wo-counry moneary union models. Erceg 3 This effec was firs illusraed by Erceg and Lindé (2014). 4 We also find a relevan role for he Periphery s endogenous deleveraging dynamics in creaing hese synergies. In paricular, while all he differen policy measures end o shoren he duraion of deleveraging in he Periphery (hus reinforcing heir expansionary effecs), hey do so by more when joinly implemened han when aken in isolaion. This channel is common o boh supplyand demand-side simuli. ECB Working Paper 1942, Augus

8 and Lindé (2013) analyze differen sraegies of fiscal consolidaion by one counry, wih a paricular aenion o he consrains imposed by currency union membership, including he possibiliy of a binding ZLB. In a similar framework, Blanchard, Erceg and Lindé (2014) sudy he spillovers of fiscal expansion in one counry o he oher under differen assumpions abou he incidence of he ZLB or he degree of home bias in governmen purchases, as well as he welfare implicaions of such an expansion. In addiion o he analysis of synergies discussed above, we also build on his lieraure by sudying he cross-counry spillovers of srucural reforms in one par of he currency union and how such spillovers depend on wheher he ZLB binds or no. The role of forward guidance abou fuure ineres raes as a means of alleviaing he resricions imposed by he ZLB is he subjec of a recen and growing lieraure, afer he seminal heoreical analysis of Eggersson and Woodford (2003). Levin e al. (2010), Campbell, Fisher and Jusiniano (2012), Del Negro, Giannoni and Paerson (2013), Benigno, Eggersson and Romei (2014) and McKay, Nakamura and Seinsson (2015) are some noable recen examples of DSGE model-based analyses of forward guidance. We complemen his lieraure by sudying, in he conex of a muli-counry moneary union model, he ineracion beween forward guidance and differen supply- and demand-side counry-specific macroeconomic policies. Our analysis reveals an imporan role of forward-guidance in srenghening he expansionary effecs of naional supply and demand side policies. Our paper is also relaed o a recen lieraure ha sudies he effecs of srucural reforms, via reducions in price and/or wage markups, in a currency union where he moneary auhoriy is eiher consrained by he ZLB (Fernández-Villaverde, Guerrón- Quinana and Rubio-Ramírez, 2012; Eggersson, Ferrero and Raffo, 2014; Gerali, Noarpiero and Pisani, 2015) or by is concern for nominal exchange rae sabilizaion (Galí and Monacelli, 2014). One conribuion of our analysis o his line of research is o add fiscal expansion by he core counries in he union and forward guidance by he moneary auhoriy, and o sudy he resuling complemenariies across hese policies. Finally, Andrés, Arce and Thomas (2015) sudy he effecs of srucural reforms in a small open economy ha belongs o a moneary union (wih he resuling lack ECB Working Paper 1942, Augus

9 of moneary accommodaion) and undergoes a prolonged process of privae-secor deleveraging due o he coexisence of long-erm deb, collaeral consrains and a negaive financial shock. 5 We build on heir analysis by considering a wo-counry moneary union srucure, which allows us o analyze he cross-counry spillovers of counry-specific policies and he synergies beween he laer policies and he common moneary policy. 6 The res of he paper is organized as follows. Secion 2 lays ou he model and presens he calibraion and soluion mehod. Secion 3 consrucs our main baseline scenario, which includes a binding ZLB and deleveraging in he periphery. Secion 4 analyzes he effecs of counry-specific macroeconomic policies (srucural reforms in he periphery, fiscal expansion in he core) and forward guidance by he common moneary auhoriy, boh wih and wihou ZLB. I hen quanifies he synergies beween hese policies. Secion 5 concludes. 2 Model We now presen a general equilibrium model of a moneary union wih wo counries or regions: he Periphery (denoed by H) and he Core (denoed by F ). union-wide populaion is normalized o 1, where a fracion s live in he Periphery and he remaining 1 s in he Core. The real side of he economy is fairly sandard. The In each counry, households obain uiliy from consumpion goods and from housing unis. Consumpion goods are produced using a combinaion of household labor, commercial real esae and equipmen capial goods. Consrucion firms build real esae (boh for residenial and commercial purposes) using labor and consumpion goods; he laer are also 5 As argued by hose auhors, he assumpion of long-erm deb brings model deb dynamics closer o hose observed in acual deleveraging episodes, boh hisorical ones and hose currenly ongoing in he euro area periphery. 6 Andrés, Arce and Thomas (2015) find a relevan role for he endogenous deleveraging dynamics ha follow a negaive financial shock in ransmiing he effecs of srucural reforms. Similarly, here we find ha deb dynamics in he Periphery can conribue o creaing posiive synergies beween he differen policies. ECB Working Paper 1942, Augus

10 used as inpus by equipmen capial goods producers. Consumpion-goods and labor markes are boh characerized by monopolisic compeiion and nominal rigidiies. On he financial side, he srucure is as follows. In each counry, here are hree ypes of consumers: paien households, impaien households, and (impaien) enrepreneurs. In equilibrium, he laer wo borrow from he former and from lenders in he oher counry. Deb conracs are long-erm. In periods in which borrowers are able o receive new credi flows, hey do so subjec o collaeral consrains. If he value of heir collaeral is oo low for hem o receive new credi flows, hey jus repay heir ousanding debs a a fixed conracual rae. Real esae is he only collaeralizable asse. We will henceforh refer o impaien and paien households as consrained and unconsrained households, respecively. Finally, a common moneary auhoriy ses he nominal policy ineres rae using a sandard Taylor rule and subjec o he ZLB consrain. All variables are in real erms and in per capia unless oherwise specified, wih he consumpion goods baske of each counry acing as he numeraire in ha counry. From now onwards, we focus on he model srucure in he Periphery counry. 7 The Core counry is modelled analogously. All equilibrium condiions, including firsorder condiions of agens opimizaion problems, are lised in Appendix A. 2.1 Households There is a represenaive consrained household and a represenaive unconsrained household, denoed respecively by superscrips c and u Cos minimizaion Before analyzing dynamic household opimizaion, we firs derive he saic cos minimizaion problem, which is common o boh households ypes (and o enrepreneurs). 7 Given our focus on he decision problems from he poin of view of he agens in he Periphery, we will also refer o hem as Home agens, and o agens in he Core as Foreign agens. Likewise, goods produced in he Periphery and he Core will also be referred o as Home and Foreign goods, respecively. ECB Working Paper 1942, Augus

11 Households consume a baske of home and foreign goods, denoed respecively by subscrips H and F, c x = ( ω 1/ε ( ) H H c x (εh 1)/ε H H, + (1 ω H ) 1/ε ( ) ) H c x (εh 1)/ε εh /(ε H 1) H F,, (1) for x = c, u; c x H, and cx F, are baskes of Home and Foreign good varieies, respecively, ( 1 c x H, = 0 ( 1 c x F, = 0 ) εp/(εp 1) c x H, (z) (εp 1)/εp dz, (2) ) ε p/(ε p 1) c x F, (z ) (ε p 1)/ε p dz, (3) where ε p, ε p > 1 are he elasiciies of subsiuion across Home and Foreign good varieies, respecively. Le P H, (z) and P F, (z ) denoe he prices of Home good variey z and Foreign good variey z respecively. Household x = c, u minimizes nominal consumpion expendiure, 1 P 0 H, (z) c x H, (z) dz + 1 P 0 F, (z ) c x F, (z ) dz, subjec o (1), (2) and (3). The firs order condiions can be expressed as for z, z [0, 1], where ( PF, ( ) εh ) εh c x PH, H, = ω H c x, c x F, = (1 ω H ) c x, (4) P P ( ) εp ( ) c x PH, (z) H, (z) = c x H,, c x F, (z PF, (z ε ) p ) = c x F,, P H, P F, P = ( ω H P 1 ε H H, + (1 ω H ) P 1 ε H F, ) 1/(1 εh ), PH, = ( 1 0 ) 1/(1 εp) P H, (z) 1 εp dz are he Periphery s consumer price index (CPI) and producer price index (PPI), respecively, and where ( 1 P F, = 0 ) 1/(1 ε p) P F, (z ) 1 ε p dz ECB Working Paper 1942, Augus

12 is a price index of Foreign goods. Nominal spending in Home and Foreign goods equal 1 P 0 H, (z) c x H, (z) dz = P H,c x H, and 1 P 0 F, (z ) c x F, (z ) dz = P F, c x F,, respecively, whereas oal nominal consumpion spending equals P H, c x H, + P F,c x F, = P c x. As noed before, consumpion goods are also used as inpus by consrucion firms and equipmen capial producers. The laer are assumed o combine home and foreign goods analogously o households. This gives rise o invesmen demand funcions analogous o (4) Unconsrained households The unconsrained household maximizes } 1 E 0 (β u ) ζ {log (c u ) + ϑ log (h u n u (i) 1+ϕ ) χ ϕ di, =0 where ζ is a union-wide shock o he discoun facor of all consumers, n u (i) are labor services of ype i [0, 1] and h u are housing unis, subjec o he following budge consrain (expressed in unis of he consumpion goods baske), c u + d + p h [ h u (1 δ h ) h 1] u R 1 1 W (i) = d 1 + (1 τ w ) n u (i) di T, π 0 P where d is he real value of ne holdings of riskless nominal deb, R is he gross nominal ineres rae a which Home agens lend and borrow, δ h is he depreciaion rae of real esae, p h is he real price of real esae, π P /P 1 is gross CPI inflaion, W (i) is he nominal wage for labor services of ype i, τ w is a ax rae on labor income and T are lump-sum axes Consrained households The consrained household s preferences are given by E 0 =0 } 1 β ζ {log (c c n c (i) 1+ϕ ) + ϑ log (h ) χ ϕ di, ECB Working Paper 1942, Augus

13 where β < β u, i.e. he consrained household is relaively impaien. The household faces he following budge consrain, c c + p h [h (1 δ h ) h 1 ] = b R 1 1 W (i) b 1 + (1 τ w ) n c (i) di T, π 0 P where b is he real value of household deb ousanding a he end of period. Unlike in mos of he lieraure, which ypically assumes shor-erm (one-period) deb, we assume ha deb conracs are long-erm. In he ineres of racabiliy, we assume ha a he beginning of ime he household repays a fracion 1 γ of all nominal deb ousanding a he end of period 1, regardless of when ha deb was issued. 8 This ype of perpeual deb is similar o he one proposed by Woodford (2001) as a racable way of modelling long-erm deb. In real erms, he ousanding principal of household deb hen evolves as follows, b = b 1 π + b new (1 γ) b 1 π = b new + γ b 1 π, (5) where b new is gross new credi ne of volunary amorizaions, i.e. amorizaions beyond he conracual deb repaymen (1 γ) b 1 /π. We assume ha, in normal imes (in a sense o be specified below), household borrowing is subjec o collaeral consrains, as in Kiyoaki and Moore (1997). Following Iacoviello (2005), ousanding deb b canno exceed a fracion m (he loano-value raio, which we assume o be exogenously ime-varying) of he expeced discouned value of he household s residenial sock: b m R 1 E π +1 p h +1h. For breviy, we will refer o such pledgeable value of collaeral as collaeral value. This deb limi, however, is only effecive as long as i exceeds γb 1 /π, which we will henceforh refer o as he conracual amorizaion pah. Indeed, if he collaeral value falls below such pah, lowering b o he value of collaeral would require lenders no only o reduce gross new credi o zero (is lower bound), bu also o impose addiional amorizaions beyond hose agreed in he conrac (i.e. b new < 0). Since 8 Toal (gross) deb paymens in each period are hen (1 γ) + (R 1 1) imes nominal deb ousanding, i.e. he sum of amorizaion and ineres paymens. ECB Working Paper 1942, Augus

14 lenders canno force borrowers o pay back faser han he conracual amorizaion rae, he conracual amorizaion pah becomes he effecive deb limi. Therefore, long run deb implies he following asymmeric borrowing consrain, b R 1 m E π +1 p h +1h, if m E π +1 p h R +1h γ b 1, (6) π b γ b 1 π, if m R E π +1 p h +1h < γ b 1 π. (7) This asymmery gives rise o a double deb regime. In normal imes in which collaeral values exceed he conracual amorizaion pah, deb is resriced by he former. In his baseline regime, households can receive new credi agains heir housing collaeral, wih he consrain ha such new credi does no exceed he gap beween collaeral values and he amorizaion pah. 9 However, in he face of shocks ha reduce collaeral values suffi cienly, he economy swiches o an alernaive regime, in which new credi disappears and deb is resriced insead by he conracual amorizaion pah. Noice ha changes from one regime o he oher ake place endogenously, and may hus be affeced by policy or by oher shocks. For fuure reference, we obain here he opimal choice of housing, λ c p h = ζ ϑ h + βe λ c +1 (1 δ h ) p h +1 + ξ m R E π +1 p h +1, (8) where λ x = ζ /c x and ξ are he Lagrange mulipliers associaed o he budge consrain of consumer ype x = c, u, e and o he collaeral consrain (eq. 6), respecively. Equaion (8) illusraes ha, when he collaeral consrain is binding (ξ > 0), he marginal value of housing is higher due o he possibiliy of borrowing agains i. This possibiliy disappears once he economy eners ino he alernaive deb regime, in which he collaeral consrain ceases o be effecive. 9 Indeed, from (5) and (6) we obain b new m R 1 E π +1 p h +1h γb 1 /π. ECB Working Paper 1942, Augus

15 2.2 Producion Enrepreneurs produce an inermediae good and sell i o reailers, who ransform i ino consumpion good varieies. Enrepreneurs and reailers conform he consumpion goods secor. In addiion, consrucion firms produce real esae, boh for residenial and commercial use, whereas equipmen capial is produced by capial goods producers. All secors operae under perfec compeiion, excep reailers who enjoy monopolisic power Enrepreneurs A represenaive enrepreneur produces an inermediae produc and sells i o reailers a a perfecly compeiive real (CPI-deflaed) price mc. The enrepreneur maximizes E 0 =0 β ζ log c e, wih he consumpion baske c e defined analogously o (1), subjec o c e +p h [ h e (1 δ h ) h 1] e +q [k (1 δ k ) k 1 ] = mc y e W n e P +b e R 1 b e π 1+ s=r,h,k Π s, y e = k α k 1 ( h e 1 ) αh (n e ) 1 α k α h, where y e is oupu of he inermediae good, k 1 is equipmen capial wih uni price q, δ k is he depreciaion rae of equipmen capial, h e 1 is commercial real esae, n e is a baske of labor services, W is a nominal wage index, b e is he real value of enrepreneurial deb ousanding a he end of period, and {Π s } s=r,h,k are real profis from he reail, consrucion and equipmen goods-producing secors. 10 Enrepreneurs maximizaion is also subjec o an asymmeric borrowing con- 10 Noice ha enrepreneurs are assumed o own he firms in he laer secors. We adop his specificaion because we are ineresed in analyzing how profi accumulaion affecs producive invesmen decisions, which in our model are made by he enrepreneurs. ECB Working Paper 1942, Augus

16 srain analogous o he one on consrained households, b e R 1 m e E π +1 p h +1h e, if me E π +1 p h R +1h e γ e be 1, (9) π b e γ e be 1 π, if me R E π +1 p h +1h e < γ e be 1 π, (10) where we allow for a differen loan-o-value raio (m e ) and conracual amorizaion rae (1 γ e ) for enrepreneurs. Again, i is insrucive o analyze here he opimal demand for commercial real esae, λ e p h = βe λ e +1 { } y+1 e mc +1 α h + (1 δ h e h ) p h +1 + ξ e m e E π +1 p h R +1, (11) where ξ e is he Lagrange mulipliers associaed o consrain (9). Analogously o he case of consrained households, in periods in which he collaeral consrain binds (ξ e > 0) he marginal value of commercial real esae is higher hanks o he possibiliy of borrowing agains i Reailers A coninuum of monopolisically compeiive reailers indexed by z [0, 1] purchase he inermediae inpu from enrepreneurs a he real price mc, and ransform i one for one ino final good varieies. Reailers real marginal cos is hus mc. Each reailer z faces a demand curve ( ) εp PH, (z) y (z) = y y d (P H, (z)), (12) P H, where y is aggregae demand of he baske of Home goods (o be derived below). Assuming Calvo (1983) price-seing, a reailer ha has he chance of seing is nominal price a ime solves max E P H, (z) s=0 (βθ p ) s λ e +s λ e [ (1 τ p ) P ] H, (z) mc +s y+s d (P H, (z)), P +s ECB Working Paper 1942, Augus

17 where θ p is he probabiliy of no adjusing he price and τ p is a ax rae on reailers revenue. The firs-order condiion is sandard (see Appendix), wih all ime- price seers choosing a common opimal price P H,. If reailers were able o rese prices in every period (θ p = 0), hey would se ε p ε p 1 P H, = 1 1 τ p ε p ε p 1 P mc. Therefore, he erm 1 1 τ p represens he desired price markup over nominal marginal cos, and hus measures he degree of monopolisic disorions in produc markes Consrucion firms A represenaive consrucion firm maximizes is expeced discouned sream of prof- is, E 0 =0 β λe Π h λ e, where Π h = p h I h 0 nology { [ ) ω I h = ( n h i h W P n h i h, subjec o he producion ech- 1 Φ h 2 ( i h i h 1 1) 2 ]} 1 ω, where n h are labor services, i h are consumpion goods, and I h are new real esae unis Equipmen capial producers A represenaive equipmen capial producer maximizes is expeced discouned sream of profis, E 0 =0 β λe λ e 0 Π k, where Π k = q I i, subjec o he echnology I = i [ 1 Φ k 2 ( ) ] 2 i 1, i 1 where i are consumpion goods, and I are new equipmen capial goods. 11 We include labor services in he producion funcion of consrucion firms so as o allow for long-run changes in real esae prices. Wihou labor in consrucion (ω = 0), real esae prices are always uniy in he long run. More generally, i can be shown ha p h ss = (w ss ) ω ω ω (1 ω) (1 ω). ECB Working Paper 1942, Augus

18 2.3 Wage seing Boh enrepreneurs and consrucion firms use a baske of labor services by consrained and unconsrained households, n s = (n s,c ) µ s (n s,u ) 1 µ s, where n s,x are labor services provided by ype-x household, x = c, u, o each secor s = e, h. We assume ha boh worker ypes (consrained and unconsrained) earn he same wage. Cos minimizaion hen implies (1 µ s ) n s,c = µ s n s,u, for s = e, h. From each household ype, each secor demands in urn a baske of labor service varieies, ( 1 n s,x = 0 ) εw/(εw 1) n s,x (i) (εw 1)/εw di, for x = c, u and s = e, h, where ε w > 1 is he elasiciy of subsiuion across labor varieies i [0, 1]. Cos minimizaion implies n s,x (i) = (W (i) /W ) εw n s,x, for x = c, u and s = e, h, where W ( 1 W 0 (i) 1 εw di) 1/(1 εw) is he nominal wage index. Toal demand for each variey of labor services is hus n x (i) n e,x (i) + n h,x (i) = ( W (i) W ) εw ( n e,x ) + n h,x n d,x (W (i)), for x = c, u. Toal nominal wage income earned by each ype-x household equals 1 W 0 (i) n x (i) di = W n x, where n x n e,x + n h,x. As in Erceg, Henderson and Levin (2000; EHL), nominal wages are se à la Calvo (1983). In paricular, a union represening all ype-i workers maximizes he uiliy of he households o which such workers belong. Then a union ha has he chance o rese he nominal wage a ime chooses W (i) o maximize x=c,u E s=0 ( (β x θ w ) s λ x +s (1 τ w ) W (i) n d,x n d,x +s (W (i)) +s (W (i)) ζ P +s χ +s 1 + ϕ ) 1+ϕ, ECB Working Paper 1942, Augus

19 where θ w is he probabiliy of no adjusing he wage and β c = β. All ime- wageseers choose a common opimal wage W ; see he firs-order condiion in he Appendix. If workers were able o rese wages in every period (θ w would charge a markup 1 1 τ w ε w ε w 1 = 0), hen hey over a weighed average of consrained and unconsrained households marginal raes of subsiuion beween consumpion and labor. Therefore, he erm 1 ε w represens he desired wage markup, and hus measures he degree of monopolisic 1 τ w ε w 1 disorions in he labor marke. 2.4 Fiscal auhoriy The fiscal auhoriy demands a baske of Home good varieies analogous o (2), which we denoe by g and is exogenously deermined. Thus, governmen demand for each Home variey z is g (z) = (P H, (z) /P H, ) εp g. Assuming full home bias in governmen purchases, he oal nominal value of governmen purchases is 1 0 P H, (z) g (z) dz = P H, g. For simpliciy, we assume ha he fiscal auhoriy balances is budge periodby-period by adjusing lump-sum axes T, W τ w (n c + n u P H, ) + τ p y + 2T = P H, g. P P 2.5 Common moneary auhoriy The common moneary auhoriy ses he gross nominal policy ineres rae R MU according o a simple inflaion-based Taylor rule and subjec o he zero bound on ne ineres raes, R MU P = max { 1, R ( ) MU π MU ρπ }, (13) where ρ π > 1, R MU is he long-run arge for he policy rae, and π MU = sπ + (1 s) π ECB Working Paper 1942, Augus

20 is a measure of he union-wide gross CPI inflaion rae, where π Foreign CPI inflaion. P /P 1 is 2.6 Inernaional linkages In secion we derived Home agens opimal demand for impored (Foreign) goods. As regards he expors side of inernaional rade, we assume ha Foreign agens demand baskes of Home good varieies analogous o (2), denoed by c c H,, cu H,, ec. The law of one price is assumed o hold for each Home good variey, such ha P H, (z) = P H, (z) for all z [0, 1], implying P H, = P H,. 12 Thus, expor demand for each Home good variey z is x (z) = (P H, (z) /P H, ) εp x, where real per capia expors equal x = 1 s s = 1 s s ( ) c c H, + c u H, + c e H, + i H, + ih, h (1 ω F ) ( PH, P ) εf ( c c + c u + c e ) + i + i h. (14) In equaion (14), ω F and ε F are he relaive weigh on Foreign goods and he elasiciy of subsiuion beween Home and Foreign goods, respecively, in Foreign agens consumpion and invesmen baskes, P is he Core s CPI, and z, z = c c, c u, c e, i, i h, are per capia demand for Home goods by he differen Foreign agens. As menioned before, Home agens can lend o and borrow from foreigners and oher domesic agens a a riskless nominal rae R. We denoe by nfa d b b e (15) he Periphery s real (CPI-deflaed) per capia ne foreign asse posiion. Following sandard pracice in he lieraure, in order o guaranee saionariy of he ne 12 The same holds for Foreign good varieies: P F, (z ) = PF, (z ) for all z [0, 1], such ha P F, = PF,. ECB Working Paper 1942, Augus

21 foreign asse posiion, we assume ha R is given by R = R MU ( exp ψ P ) nfa, P H, gdp where ψ > 0 and gdp is he real (PPI-deflaed) per capia GDP, o be derived laer. 2.7 Aggregaion and marke clearing Each reailer z demands y d (P H, (z)) unis of he inermediae inpu, as given by (12). Toal demand for he laer equals 1 0 yd (P H, (z)) dz = y, where 1 (P 0 H, (z) /P H, ) εp dz denoes relaive price dispersion. Marke clearing in he inermediae good marke hus requires k α k 1 ( h e 1 ) αh (n e ) 1 α h α k = y. Aggregae demand for he baske of Home good varieies is given by, y = c c H, + c u H, + c e H, + i H, + i h H, + g + x. (16) Toal demand for real esae mus equal oal supply, h + h u + h e = I h + (1 δ h ) ( h 1 + h u 1 + h e 1). Toal demand for equipmen capial mus equal oal supply: k = I + (1 δ k ) k 1. Labor marke clearing requires n c + n u = n e + n h. We define real (PPI-deflaed) per capia GDP as gdp y + P (q I i ) + P ( ) p h P H, P I h i h H, = P c o + P ( q I + p h I h P H, P H, ) + [x P F, P H, ( c o F, + i F, + i h F,) ], ECB Working Paper 1942, Augus

22 where in he second equaliy we have used (16) and z H, = P P H, z P F, P H, z F, for z = c c, c u, c e, i, i h, and where c o c c +c u +c e is oal consumpion (oal consumpion impors c o F, are defined analogously). Zero ne supply of nominal inernaional bonds requires sp nfa + (1 s) P nfa = 0, where he Core s real per capia ne foreign asse posiion, nfa, is defined analogously o (15). We may combine all domesic marke-clearing condiions and budge consrains o obain he Periphery s curren accoun ideniy, nfa = R 1 π nfa 1 + P H, x P F, ( c o F, + i F, + i P P F,) h. 2.8 Calibraion and soluion mehod We calibrae our wo-counry moneary union model o he euro area, where he counry labelled Periphery broadly represens he member saes in he so-called euro area Periphery. As explained in he inroducion, we are moivaed by he recen experience of he peripheral euro area economies, where he privae secor is sill embarked in a gradual deleveraging process, and for which srucural reforms in produc and labor markes have been advocaed as a means of fosering economic recovery. The share of he oal populaion ha lives in he Periphery is se o s = 1/3, following Blanchard e al. (2014). The res of he calibraion closely follows Andrés, Arce and Thomas (2014), who calibrae a similar model o he Spanish economy. 13 The ime period is a quarer. Some parameers will be calibraed by maching he model s seady sae o a number of empirical arges in 2007, he year prior o he sar of he inernaional financial crisis We hus op for calibraing he Home counry o Spain, raher han building consolidaed aggregaes for he peripheral euro area economies. 14 We do no claim, however, ha he Spanish economy was in (or close o) a seady sae in Insead, our model s seady sae should be inerpreed as he economy s iniial condiion for he purpose of our simulaion exercises. ECB Working Paper 1942, Augus

23 The discoun facor of he impaien agens is se o β = 0.98, following Iacoviello (2005). For paien households, we choose β u = /4, which is consisen wih a seady sae nominal ineres rae of R ss = /4 π ss = R MU e ψ(nfay ss). We se he long-run inflaion arge π MU o 1, which implies π ss = π ss = 1 in a saionary equilibrium. Choosing R MU = /4 for he nominal policy ineres rae, we hen se ψ o replicae ne foreign asses over GDP in 2007, nfa y ss = 79.3%. The inverse labor supply elasiciy is se o ϕ = 4, consisenly wih a large body of micro evidence. The weigh parameer in he consumpion baske, ω H, is se o mach gross expors over GDP in 2007 (26.9%). Based on evidence for Spain in García e al. (2009), he price elasiciy of expors and impors is se o ε F = ε H = 1. The elasiciies of subsiuion across varieies of consumpion goods and labor services, ε p and ε w, and he ax raes on reailers revenue and labor income, τ p and τ w, deermine he desired markups in produc and labor markes, respecively. We se ε p = 7 and τ p = 0, implying an iniial price markup of (1 τ p ) 1 ε p /(ε p 1) = 1.17, which is broadly consisen wih esimaes by Monero and Urasun (2013) based on Spanish firm-level daa. Wage markups are hard o esimae empirically, so we adop an alernaive calibraion sraegy. We follow Galí (2011) in reinerpreing he EHL model of wage-seing in a way ha delivers equilibrium unemploymen (see Appendix B for deails). Targeing an unemploymen rae of 8.6% in 2007, we obain an iniial wage markup of (1 τ w ) 1 ε w /(ε w 1) = 1.43, which we achieve by seing τ w = 0 and ε w = The elasiciy of enrepreneurial oupu wih respec o equipmen capial and commercial real esae are se o α k = 0.11 and α h = 0.21, which are chosen o replicae he labor share of GDP in 2007 (61.6%) and he share of equipmen capial in he oal sock of producive capial. 16 As in Iacoviello and Neri (2010) we se δ h = 0.01, 15 Our choice of τ p and τ w is moivaed as follows. In his paper, we implemen srucural reforms by changing he elasiciy parameers ε p and ε w. Seing τ p = τ w = 0 allows us o isolae he effecs of srucural reforms from addiional fiscal effecs operaing hrough he budge consrain of consrained households (in paricular, hrough changes in lump-sum axes T ). See Andrés, Arce and Thomas (2015) for a discussion of he effecs of reforms implemened via reducions in τ p and τ w. 16 Using daa from BBVA Research, we obain ha he value of equipmen capial was 21.4% of he oal value of producive capial in ECB Working Paper 1942, Augus

24 Table 1: Calibraion Parameer Value Descripion s 1/3 relaive size of Home counry Preferences β u, β u unconsrained household discoun facor β, β 0.98 consrained household discoun facor ϕ, ϕ 4 (inverse) labor supply elasiciy ϑ, ϑ 0.38 weigh on housing uiliy ε p, ε p 7 elasiciy of subs. across consumpion varieies ε w, ε w 3.31 elasiciy of subsiuion across labor varieies ω H, ω F 0.72, 0.86 weigh on domesic goods in consumpion baske ε H, ε F 1 elas. of subs. beween domesic and impored goods Technology α h, α h 0.21 elasiciy oupu wr real esae α k, α k 0.11 elasiciy oupu wr equipmen ω, ω 0.43 elasiciy consrucion wr labor δ h, δ h 0.01 depreciaion real esae δ k, δ k depreciaion equipmen µ, µ 0.5 share of consr. households in labor baskes Φ h, Φ h 6.1 invesmen adjusmen coss consrucion Φ k, Φ k 2.4 invesmen adjusmen coss equipmen Price/wage seing θ p, θ p 0.67 fracion of non-adjusing prices θ w, θ w 0.75 fracion of non-adjusing wages Deb consrains m, m 0.70 household LTV raio m e, m e 0.64 enrepreneur LTV raio γ, γ 0.98 amorizaion rae household deb γ e, γ e 0.97 amorizaion rae enrepreneurial deb Moneary policy φ, R MU 1.5, /4 Taylor rule coeffi cien, long-run policy rae ECB Working Paper 1942, Augus

25 whereas δ k is se o a sandard value of The elasiciy of consrucion oupu wih respec o labor ω is se o mach he consrucion share of oal employmen in 2007 (13.4%). The weigh of uiliy from housing services, ϑ, is chosen o replicae gross household deb over annual GDP (80.2%). The share of consrained and unconsrained workers in he labor baskes are se o µ h = µ e µ = 1/2. The scale parameers of convex invesmen adjusmen coss, Φ h and Φ k, are chosen such ha he fall in consrucion and equipmen capial invesmen in our baseline deleveraging scenario resembles heir behavior during he crisis. 17 The Calvo parameers are se o θ p = 2/3 and θ w = 3/4, such ha prices and wages are adjused every 3 and 4 quarers on average, respecively. This is consisen wih survey evidence for he Spanish economy (see e.g. Druan e al., 2009). The parameers ha regulae he deb consrains are calibraed as follows. According o daa from he Spanish Land Regisry offi ce, loan-o-value raios (LTV) for new morgages prior o he crisis were slighly below 70 percen. We hus se m = 0.70 for he household s iniial loan-o-value raio. The enrepreneurial iniial loan-o-value raio is chosen o mach he raio of gross non-financial corporae deb o annual GDP (125.4% in 2007), which yields m e = Finally, we calibrae he conracual amorizaion raes, 1 γ and 1 γ e, in order o replicae he average age of he sock of ousanding morgage deb prior o he crisis. This yields 1 γ = 0.02 and 1 γ e = 0.03 per quarer. 18 For he Core, for simpliciy we assume a fully symmeric calibraion, wih wo excepions. Firs, he weigh on Periphery goods in he consumpion baske of Core consumers, ω F, is se in order o normalize he erms-of-rade in he iniial seady 17 In paricular, we se Φ h and Φ k such ha he accumulaed fall in consrucion and equipmen capial invesmen 8 quarers afer he financial shock replicae heir accumulaed fall 8 quarers afer heir peak in 2007:Q4 (24.5% and 28% respecively). 18 Under our deb conracs (wih a consan fracion of ousanding deb amorized each period), he average age of he deb sock converges in he seady sae o γ/ (1 γ) and γ e / (1 γ e ) for households and enrepreneurs, respecively. According o calculaions by Banco de España, based on daa from he Land Regisry offi ce and large financial insiuions, he average age of ousanding morgage deb prior o he crisis was close o 12.5 years for households and 8 years for nonfinancial corporaions and enrepreneurs. This yields γ = /( ) = 0.98 and γ e = 8 4/( ) = ECB Working Paper 1942, Augus

26 sae o Second, we allow for an addiional parameer in he ineres rae premium of he Core and se i such ha ineres raes are he same in boh counries in he iniial seady sae. 20 Finally, we assume a sandard value of 1.5 for he Taylor rule coeffi cien φ, which ogeher wih he long-run arge for he policy rae chosen above ( R MU = /4 ) complees he specificaion of he moneary policy rule. Table 1 summarizes he calibraion Soluion mehod We assume perfec foresigh in all our simulaions. We solve for he fully nonlinear equilibrium pah, using a varian of he Newon-Raphson algorihm developed by Laffargue (1990), Boucekkine (1995) and Juillard (1996) (LBJ). As discussed in he previous secion, our assumpion of long-run deb conracs gives rise o wo deb regimes for households and enrepreneurs. If collaeral values are above he conracual deb amorizaion pahs, hen deb levels are resriced by he former, according o equaions (6) and (9). If he opposie holds, hen new credi flows collapse o zero and deb is resriced by he conracual amorizaion pah (equaions 7 and 10). Moreover, he presence of he ZLB on nominal ineres raes (see equaion 13) implies ha he economy may also swich endogenously beween wo moneary policy regimes, depending on wheher he ZLB binds or no. We have herefore exended he LBJ algorihm o allow for endogenous changes of boh deb and moneary policy regimes. In paricular, he daes a which hese regime changes ake place are solved as equilibrium objecs. 19 Unlike in he case of ω H, which was calibraed o mach an expors arge for he Home counry (equivalenly, an impors arge, given he arge for he NFA-o-GDP raio), ω F canno be argeed o he Foreign counry s expors because hese mus equal he Home counry s impors in he model. 20 In paricular, we assume R = R MU exp [ ψ (P nfa /P F, gdp ) + ψ 0], wih ψ = ψ, and se ψ 0 such ha R ss = Rss. ECB Working Paper 1942, Augus

27 3 Baseline scenario: deleveraging and he ZLB In his secion we consruc a baseline scenario ha is mean o capure some imporan feaures of he curren economic siuaion in he euro area and, paricularly, in is peripheral economies. On he one hand, he laer economies are experiencing a proraced process of privae-secor deleveraging. Wih his aim, we will firs simulae he effecs of a deleveraging shock in he Periphery, assuming he common moneary auhoriy is able o reduce nominal ineres raes so as o parially counerac he resuling fall in union-wide inflaion. On he oher hand, he European Cenral Bank is currenly resriced in is abiliy o furher reduce nominal ineres raes, as he laer are already very close o he zero bound. Thus, we will consider a second scenario in which, simulaneously o he deleveraging shock, a negaive union-wide demand shock occurs ha pushes he moneary auhoriy s nominal ineres rae agains is ZLB. The laer scenario, wih boh privae secor deleveraging in he Periphery and a binding ZLB, will consiue he main baseline scenario wih respec o which we will evaluae he effecs of, and synergies beween, alernaive macroeconomic policies. 3.1 Adjusmen o deleveraging ou of he ZLB In order o beer undersand he effecs of a deleveraging shock in our model of collaeral consrains and long-run deb, we firs subjec he model economy o a negaive financial shock in he Periphery ha reduces he availabiliy of credi for borrowers. Our credi crunch consiss of an unexpeced, gradual, permanen drop in he LTV raios of boh households and enrepreneurs, m and m e respecively. In paricular, we assume an auoregressive process for boh LTV raios: x = (1 ρ x ) x + ρ x x 1, x = m, m e, where we se ρ m = ρ me = We hen simulae an unanicipaed fall in he long-run LTV raios ( m, m e ) of 7.5 percenage poins from heir baseline values in Table 1, which accords well wih recen experience in Spain Daa from he Spanish Land Regisry offi ce shows ha average LTV raios for new morgages declined by 7.7 percenage poins in he 6 years beween 2007:Q3 and 2013:Q3. ECB Working Paper 1942, Augus

28 Figure 1: Deb dynamics afer a deleveraging shock in he Periphery Figure 1 displays he response o he credi crunch of collaeral values and conracual amorizaion pahs, ogeher wih he acual equilibrium pah of ousanding deb, boh for enrepreneurs and households in he Periphery. Before he shock ( = 0), he economy ress in he seady sae of he baseline regime, where deb levels equal pledgeable collaeral values. 22 The credi crunch shock drives collaeral values below he conracual amorizaion pahs already on impac ( = 1). Therefore, he economy swiches on impac o he alernaive regime in which enrepreneurial and household deb socks decay a he conracual amorizaion raes. In his phase, he economy undergoes a gradual and prolonged deleveraging process. Evenually, collaeral values rise again above he conracual amorizaion pah, a which poin borrowers are able o regain access o fresh funds. We denoe by T and T he ime a which he endogenous regime change akes place for enrepreneurs and households, respecively. Noice ha collaeral values and deb boh experience a surge a he ime of he regime change. This is because real esae becomes again 22 Indeed, he fac ha consrained households and enrepreneurs are boh more impaien han unconsrained households, β < β u, guaranees ha he collaeral consrain binds for boh agens in he seady sae. ECB Working Paper 1942, Augus

29 valuable as collaeral (see equaions 8 and 11), which pushes up borrowers demand for real esae, and hence is price. Thus, T and T also represen he duraion of he deleveraging phase for enrepreneurs and households. In he scenario analyzed here, he equilibrium duraion of he deleveraging phase is T = 10 quarers for enrepreneurs and T = 17 quarers for households, he laer being longer due mainly o he lower amorizaion rae of household deb (1 γ < 1 γ e ). 23 Figure 2 shows he response of boh counries o he deleveraging shock in he Periphery. 24 In he laer, he shock produces a deep and proraced recession, which ends around he period in which enrepreneurs regain access o new loans ( = 10). Such recession is due o he fall in domesic demand (consumpion and invesmen); he laer is only parially couneraced by an improvemen in ne expors, hanks o he Periphery s improvemen in compeiiveness vis-à-vis he Core in he firs few years and he conracion in domesic demand. 25. The resuling union-wide deflaion leads he moneary auhoriy o reduce nominal ineres raes according o he Taylor rule, which produces a mild economic expansion in he Core. 3.2 Adjusmen o deleveraging a he ZLB We move nex o our main baseline scenario, where, conemporaneously o he deleveraging shock in he Periphery, a common negaive demand shock affecs boh counries. In paricular, we assume an unanicipaed emporary increase in consumers discoun facors. Assuming ζ = ζ ρ ζ 1e uζ, we se u ζ 1 = 0.005, i.e. discoun facors increase on impac by 2 annualized percenage poins, and ρ ζ = 0.90; we choose his calibraion such ha he shor-run fall in union-wide GDP replicaes 23 Figure 1 shows ha he deb consrains (7) and (10) are binding during = 1,..., T 1 and = 1,..., T 1, respecively, whereas he collaeral consrains (6 and 9) are binding for T and T, respecively. We have verified ha he corresponding Lagrange mulipliers are indeed sricly posiive in he relevan periods, boh in he baseline scenario and in all subsequen simulaions. Resuls are available upon reques. 24 In all figures, all variables are in %, excep ineres raes (real and nominal), which are in annualized percenage poins. 25 The response of variables such as consumpion, invesmen, erms-of-rade and ne expors are no shown in he figures for breviy, bu are available upon reques. ECB Working Paper 1942, Augus