EUROPEAN ECONOMY EUROPEAN COMMISSION DIRECTORATE-GENERAL FOR ECONOMIC AND FINANCIAL AFFAIRS

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1 EUROPEAN ECONOMY EUROPEAN COMMISSION DIRECTORATE-GENERAL FOR ECONOMIC AND FINANCIAL AFFAIRS ECONOMIC PAPERS ISSN hp://ec.europa.eu/economy_fnance/ndex_en.hm N 66 December 6 Fscal polcy n an esmaed open-economy model for he Euro area by Marco Rao, Werner Roeger, Jan n Veld Drecorae-General for Economc and Fnancal Affars

2 Economc Papers are wren by he Saff of he Drecorae-General for Economc and Fnancal Affars, or by expers workng n assocaon wh hem. The Papers are nended o ncrease awareness of he echncal work beng done by he saff and o seek commens and suggesons for furher analyses. Vews expressed represen exclusvely he posons of he auhor and do no necessarly correspond o hose of he European Commsson. Commens and enqures should be addressed o he: European Commsson Drecorae-General for Economc and Fnancal Affars Publcaons BU - -/3 B - 49 Brussels, Belgum ISBN KC-AI-6-66-EN-C European Communes, 6

3 Fscal Polcy n an Esmaed Open-Economy Model for he Euro Area Marco Rao, Werner Roeger, Jan n Veld European Commsson Ocober 6 Absrac Ths paper uses an esmaed DSGE model for he euro area o sudy he effecs of fscal sablsaon polces. There are a leas wo feaures of he euro area economy whch makes hs analyss neresng. Frs, here are nomnal rgdes n goods and labour markes, and here are fnancal marke frcons wh a sgnfcan share of lqudy consraned households. Second, he governmen s a maor secor of he euro area economy. In hs paper we look a fscal sablsaon va governmen consumpon, nvesmen, ransfers and wage axes. We fnd emprcal evdence for sysemac counercyclcal fscal polcy. Conssen wh prevous fndngs, here s a small posve fscal mulpler n he case of ransory fscal shocks. We fnd ha fscal polcy s effecve n sablsng GDP n he presence of demand and supply shocks. Fscal polcy helps o reduce he demand exernaly arsng from nomnal rgdes. In addon auomac sablsaon va governmen ransfers helps o smooh consumpon of lqudyconsraned household. Fscal polcy parly compensaes he fnancal marke dsoron. Wh dsored goods, labour and fnancal markes we fnd ha he esmaed fscal polcy rules reduce flucuaons n euro area GDP by abou 4 percen. JEL Classfcaon Sysem: E3, E6 Keywords: DSGE modellng, fscal polcy, sablsaon polces, euro area We have benefed from helpful commens by Bernhard Herz, Lorenzo Forn, our colleagues a DG ECFIN and JRC and oher parcpans a he CEF 6 conference n Lmassol, Cyprus, he EEA-ESEM 6 conference n Venna and he European Commsson conference on "Fscal Sablsaon Polces n a Moneary Unon: Wha can we learn from DSGE models?" n Brussels. The vews expressed n hs paper are hose of he auhors and do no necessarly represen hose of he European Commsson. Correspondence: Rao, Jon Research Cenre, European Commsson, Ispra, Ialy, e-mal: marco.rao@rc.; Roeger: DG ECFIN, European Commsson, Brussels, Belgum, e-mal: werner.roeger@ec.europa.eu; n ' Veld: DG ECFIN, European Commsson, Brussels, Belgum, e-mal: an.nveld@ec.europa.eu. 3

4 Inroducon In recen years consderable progress has been made n he esmaon of New-Keynesan dynamc sochasc equlbrum (DSGE models. Because hese models explcly derve behavoural equaons from neremporal opmsaon of he prvae secor under echnologcal, budge and nsuonal consrans such as mperfecons n facor, goods and fnancal markes, hey are well sued o analyse he mpac of fscal and moneary polcy. In hs framework, macroeconomc flucuaons are seen as he opmal response of he prvae secor o demand and supply shocks n varous markes, gven he consrans menoned above. Therefore, hey allow us o analyse o wha exen fscal and moneary polces can allevae exsng dsorons by appropraely respondng o macroeconomc shocks. DSGE models have so far been used exensvely o sudy he effecs of moneary polcy and he sablsng role of moneary rules. In parcular has been demonsraed ha an acve role for moneary polcy arses from he presence of nomnal rgdes n goods and facor markes. So far, no much work has been devoed owards explorng he role of fscal sablsaon n he New Keynesan model. Emprcal work has concenraed manly on an analyss of he effecs of governmen spendng shocks. (see Gal e al. (3, Coenen and Sraub (5 and Forn e al. (6. Ths work was movaed by undersandng correlaon paerns beween fscal varables and prvae consumpon n macroeconomc me seres. To our knowledge, less aenon has been devoed o an emprcal analyss of he sablsng role of fscal polcy self. Ths paper herefore exends hs leraure by focussng on an analyss of he magnude of fscal sablsaon n he euro area a an aggregae level,.e. we ask he queson, wha has been he sablsng power of fscal polcy n respondng o euro area wde shocks over he perod 98-5? There are a leas wo feaures of he euro area economy whch makes hs analyss neresng. Frs, markes n he euro area do no funcon perfecly. There s subsanal emprcal evdence ha prces and wages adus sluggshly o supply and demand shocks as documened n numerous sudes of wage and prce behavour, sarng from early Phllps curve esmaes (see, for example, Phelps (967 and exendng o recen esmaes usng boh backward as well as forward lookng prce and wage rules (see e.g. Gal e al. (. The recen work by Gal e al. (3, Coenen and Sraub (5 and Forn e al. (6 has also hghlghed he presence of lqudy consrans as an addonal marke mperfecon. The nroducon of non-rcardan behavour n he model could gve rse o a role for fscal sablsaon, snce lqudy consraned households do no respond o neres rae sgnals and here s lle ha can be done by moneary polcy. Second, he governmen secor forms a maor share of he euro area economy. Governmen consumpon consues % of GDP. Governmen ransfers o households make up a smlar share. The laer help o smooh ncome of prvae households over he busness cycle, especally n he form of pensons and unemploymen nsurance. Governmen expendure s fnanced by consumpon, labour ncome and capal axes. The ax sysem, especally he ncome ax, provdes addonal sablsaon va a progressve ax code. Obvously, a prerequse for such an analyss s a proper emprcal represenaon of he daa generang process. The semnal work of Smes and Wouers (3 has shown ha DSGE models can n fac provde a sasfacory represenaon of he man macroeconomc aggregaes. Ths paper exends he basc DSGE model n four drecons. Frs, respecs he un roo 4

5 characer of macroeconomc me seres by allowng for sochasc rends n TFP, second reas he euro area as an open economy, hrd adds fnancal marke mperfecons n he form of lqudy consraned households o mperfecons n he form of nomnal rgdes n goods and labour markes and, fourh, nroduces a governmen secor wh sablsng demand polces. We emprcally denfy governmen spendng rules by specfyng curren governmen consumpon and ransfers as funcons of her own lags as well as curren and lagged oupu and unemploymen gaps. In oher words, our fscal rules resemble he well-known Taylor rule for neres raes. However, we do no fnd a sgnfcan response of fscal polcy o devaons of nflaon from he arge rae. From he operaon of he euro area unemploymen nsurance sysem we know ha unemploymen benefs provde quas-auomac ncome sablsaon. Indeed we fnd a sgnfcan response of ransfers o cyclcal varaons n employmen. A pror governmen consumpon s no explcly counercyclcal, hough can already provde sablsaon by keepng expendure fxed n nomnal erms over he busness cycle. The emprcal evdence suggess ha fscal polcy s used n a counercyclcal fashon n he euro area. The queson we focus on n hs paper s how much sablsaon s provded by acve fscal polcy, akng no accoun all he sochasc shocks ha we denfy over he perod 98Q o 5Q3. We fnd ha fscal polcy has reduced he sandard devaon of oupu growh by abou 4 percen over ha perod. Our resuls can be compared o oher papers ha have nvesgaed he sablsng effecs of fscal polcy. Faas and Mhov (3 queson he convenonal wsdom ha fscal polcy s counercyclcal. They nvesgae he effec of dscreonary polcy and use governmen spendng daa for a large cross-secon of counres. They regress governmen spendng growh on oupu growh (and addonal conrol varables and nerpre he resdual of he esmaed equaon as he ndcaor of he dscreonary spendng shock. They fnd ha hghly volale dscreonary fscal polcy exers a srong desablsng effec on he economy. The volaly of oupu nduced by dscreonary fscal polcy lowers economc growh by more han.8 percenage pons for every percenage pon ncrease n volaly. Ars and Onorane (6 analyse wheher n he pas dscreonary fscal polcy n EMU has been effecve n smoohng he economc cycle, or wheher fscal polcy has been procyclcal and ncreased he amplude of he cycle. They esmae a small model for growh, he defc rao and nflaon and compare he varance of synhec economc cycles creaed by shung down he permanen shock of he esmaed srucural model and producng counerfacual economc cycles by changng assumpons on he fscal shocks. They fnd ha fscal polcy has had overall a lmed, f any, smoohng effec on he cycle. Shung down he dscreonary componen of fscal polcy approaches closes he bes fscal polcy n her smulaons. Our paper s srucured as follows. In secon one we descrbe he model and characerse he shocks hng he euro area economy. Secon wo brefly presens he emprcal f of our DSGE model. Secon hree analyses fscal sablsaon and secon four concludes.. The Model We consder an open economy whch faces an exogenous world neres rae, world prces and world demand. The domesc and foregn regons produce a connuum of dfferenaed goods. 5

6 The goods produced n he home counry are mperfec subsues for goods produced abroad. The model economy s populaed by households and frms and here s a moneary and fscal auhory, boh followng rules based sablsaon polces. We dsngush beween households whch are lqudy consraned and consume her dsposable ncome and households who can rade on fnancal markes.. Frms: There s a fnal goods and an nvesmen goods producon secor, populaed wh wo ypes of frms. In he fnal goods secor n d frms ndexed by produce goods whch are mperfec subsues Fnal oupu s consumed by prvae households and he governmen (domesc and abroad and serves as an npu for a perfecly compeve nvesmen goods secor. Frms n he nvesmen goods secor ransform fnal goods no a sngle nvesmen good whch s used n he fnal goods secor. Frms are owned by households and pay dvdends... Fnal oupu producers Each frm produces a varey of he domesc good whch s an mperfec subsue for varees produced by oher frms. Because of mperfec subsuably, frms are monopolscally compeve n he goods marke and face a demand funcon for goods. Domesc frms sell o prvae domesc households, o oher frms he governmen and o exporng frms. All demand secors have dencal CES preferences across varees, wh a me-varyng elascy of subsuon /τ. The demand funcon for frm conssen wh preferences (see secon.4 for a more dealed descrpon s gven by P D D D ( [( ] Y = C + G + I + EX n d P τ In wha follows s assumed ha frms nfluence he demand for domesc goods wh her prcng decson, however, hey are small wh respec o he oal marke and herefore ake as gven P, PC, C, G, I and EX. Oupu s produced wh a Cobb Douglas producon funcon ( Y = ( ucap K α ( L LO α U α = ( ucap K α [ L α ( LOL ] ( U α wh capal ( K and labour ( L mnus overhead labour ( LO as npus. θ θ L s self a CES θ, aggregae of labour suppled by ndvdual households, L = θ L d where he parameer θ > deermnes he degree of subsuably. Frms also decde abou he degree of capacy ulsaon ( ucap. The echnology shock U follows a random walk wh drf (3a U U U = g + U + e, e ~ N(, σ U U 6

7 And he drf erm U g follows an AR( process (3b g U U GU GU U = g + ρ g GU GU GU ( ρ + ε ε ~ N(, σ We allow he share of overhead labour value LOL o follow an AR( process around s long run (4 LOL LOL LOL = LOL + ρ LOL LOL LOL LOL ( ρ + ε, ε ~ N(, σ The obecve of he frm s o maxmse he presen dscouned value of s cash flows. The lnk o he household secor s as follows. Domesc frms are owned by domesc households. All nvesmen s equy fnanced and he frms pay dvdends o he household secor. Dynamc consderaons ener he problem of he frms because frms face quadrac coss of changng capal, employmen and prces. Fnally frms mus also choose he opmal level of capacy ulsaon. (5 Max V r = E = d μ d p P L CAP K [( ( P (. Y W L adc ( P ad ( L ad ( ucap PI I ad ( K ] η d ( α α [ Y ( ucap K ( L ( LOL U ] [ K I ( δ K ] p l where d = s he dscoun facor, whch consss of he shor erm neres rae l= + rl + rpl and a rsk premum (rp. The rsk premum can be subec o random shocks and generaed by he followng auoregressve process P (6 rp rp rp rp rp rp = ρ rp + ( ρ rp + ε, ε ~ N(, σ For adusmen coss we choose he followng convex funconal forms. (7 ad CAP ad ad L P ( L = W ( L e γ P ( P = ( P L γ L + ΔL P P I K γ K ( + e I γ I ( I I ad ( K = +, I PI K I ( ucap = PIK ( a ( ucap ucap* + a( ucap ucap*, wh ucap*=. The adusmen coss for capal and labour are subec o auocorrelaed random shocks 7

8 8 I I I I e e ε ρ + = wh (, ~ I I N σ ε L L L L e e ε ρ + = wh (, ~ L L N σ ε The frm deermnes labour npu, he capal sock, capacy ulsaon and prces opmally n each perod gven he echnologcal and admnsrave consrans as well as demand condons. The frs order condons, neglecng second order erms, are gven by: (8a ( ( ( ( L L L e P W L L P W L L R P W LOL L Y + = γ γ η α (8b L W W L θ =,, wh θ θ = W W (8c ( ( = Δ + Δ I I I I K PI P I I I I K I e μ π π βγ γ γ (8d p p rp r ucap a ucap a a a a P PI K Y ( ( ( (( ( ( + = + + μ δ μ η α (8e ucap K Y ucap a a P PI η α ( ( ( = + (8f [ ] P e π π β γ τ η τ + = + ( Frms equae he margnal produc of aggregae labour, ne of labour adusmen coss o he real wage rae (eq. 8a. As can be seen from he lef hand sde of equaon (8a, he convex par of he adusmen cos funcon penalses changes n employmen. In a second sep frms decde abou demand for dfferen varees of labour (8b. Equaons (8c-e only deermne he opmal capal sock and opmal capacy ulsaon. The frm equaes he margnal produc of capal o he renal prce of capal, adused for capal coss. The frm also equaes he margnal produc of capal servces (K*ucap o he margnal cos of capacy ulsaon. Equaon (8f defnes he mark up facor as a funcon of he elascy of subsuon and changes n nflaon. We follow Smes and Wouers and allow for addonal backward lookng elemens by assumng ha a fracon (-sfp of frms keep prces fxed a he - level. Ths leads o he followng specfcaon: (8e [ ] P sfp sfp e π π π β γ τ η τ + + = + ( * ( ( sfp wh τ τ τ τ ε ρ e e + =, (, ~ τ τ σ ε N... Invesmen goods producers There s a perfecly compeve secor whch combnes domesc and foregn fnal goods, usng he same CES funcons as households and governmens do o produce nvesmen goods for he domesc economy. Denoe he aggregae of domesc and foregn npus used by he nvesmen

9 goods secor wh I np, hen real oupu of he nvesmen goods secor s produced by he followng lnear producon funcon, (9 I = I np U I I where U s a echnology shock o he nvesmen good producon echnology whch self follows a random walk wh rend ( log( e wh I UI I U = g + log( U + UI e UI UI UI UI UI UI = ρ e + ε and ε ~ N(, σ Gven our assumpon concernng he npu used n he nvesmen goods producon secor, nvesmen goods prces are gven by ( PI = PC / U. I. Households: h. A share ( slc of hese. They have full access o fnancal markes, hey buy and sell domesc and foregn asses (governmen bonds and equy. The remanng share slc of households s lqudy consraned and ndexed by k [ slc,]. These households do no rade on asse markes and consume her dsposable ncome each perod. We follow Coenen e al. (5 and assume ha boh ypes of households supply dfferenaed labour servces o unons whch ac as wage seers n monopolscally compeve labour markes. The unons pool wage ncome and dsrbue n equal proporons among her members. Nomnal rgdy n wage seng s nroduced by assumng ha he household faces adusmen coss for changng wages. These adusmen coss are borne by he household. The household secor consss of a connuum of households [,] households are no lqudy consraned and ndexed by [, slc.. Non Lqudy consraned households Each non lqudy consraned household decdes abou four ypes of asses, domesc and F foregn nomnal bonds ( B, B, socks of domesc companes ( Q and cash balances ( M. Households maxmze an neremporal uly funcon subec o a budge consran. The Lagrangan of hs maxmsaon problem s gven by: K 9

10 ( Max U = E = β ( U ( C + V ( L + Z( M / P c, F ( + PC M B E B PCQ K M ( + B C P P P P P P P F F E B F ( + ( rsk( E B w P + Y ( dv PCQ K ( W λ β P P P γ wl ( W W NETTR + P W P L The uly funcon s addvely separable n consumpon ( C and lesure ( L. We assume CES uly for consumpon and for lesure and n addon we allow for hab perssence. Thus emporal uly for consumpon s gven by (3a ( habc U ( C = e c ( σ exp( C ( C habcc c σ and for lesure (3b κ >. ω κ NPART NPART κ V ( L = ( + habl (( + habl( L e habl( L e wh C The varable e denoes auocorrelaed shock o preferences: C C C C C C e = ρ e + ε, ε ~ N(, σ NPART and e denoes an auocorrelaed shock o he share of households non-parcpang n he NPART NPART NPART NPART NPART NPART labour force e = ρ e + ε, ε ~ N(, σ. The consumpon ndex s self an aggregae over varees of domesc and foregn goods whch are mperfec subsues. These preferences are expressed by a nesed CES uly funcon. I s assumed ha households, frms and he governmen have dencal preferences over domesc and foregn varees n order o faclae aggregaon. The sub uly funcons are descrbed n more deal n secon.4 below. The household decdes abou consumpon, asse allocaon, he supply of labour and real money holdngs. As shown by he budge consran, he household has four sources of ncome, ne w labour ncome ( ( W L, ne ransfer ncome from he governmen ( NETTR, dvdend Wh an neres rae rule as specfed below, an opmaly condon for money would only deermne he desred money holdngs of he household secor whou any furher consequence for he res of he economy. For ha reason any furher dscusson on money demand s dropped here.

11 ncome from he domesc corporae secor ( dvpcq K and neres ncome from governmen and foregn bonds. A radng frcon for foregn bonds s nroduced, expressed as a funcon of F RPE he ne foregn asse o GDP rao ( rsk ( E B Y + e and an auocorrelaed random shock RPE RPE RPE RPE RPE RPE e = ρ e + ε, wh ε ~ N(, σ. The rsk premum capures he cos for he domesc household of underakng posons n he nernaonal capal marke. As borrower, he household s charged a premum on he foregn neres rae and as lender he receves a remuneraon whch s below he foregn neres rae. The frs order condons of he household wh respec o consumpon and fnancal wealh are gven by he followng equaons: c U ( + (4a PC => U = C, λ C P U P (4b => λ + ( + = λ+ β B P U F NFA P E (4c => λ + λ+ β ( + ( rsk( = F B PY P E (4d U K PC Q (( + dv PC Q + + => λ + = λ+ β P P + From he FOC we oban he followng arbrage equaons (4b ( + P P + = ( + F NFA ( rsk( PY E E + P P + (4d ( + P P + = ( + dv Q Q + PC PC + P P + The frs arbrage condon requres ha up o a rsk premum, he reurn from a domesc bond s equal o he reurn from a foregn bond expressed n he domesc currency. The second arbrage condon requres ha he reurn from equy,. e. dvdends plus changes n he value of he capal sock plus changes n he prce of capal goods s equal o he nomnal neres rae... Lqudy consraned households Lqudy consraned households do no opmze bu smply consume her enre labour ncome a each dae. Real consumpon of household k s hus deermned by ne wage ncome plus ransfers c c k w k w k (5 ( + P C = ( W L + NETTR = ( W L + TR Tax

12 ..3 Wage seng Workers from each household have marke power n he labour marke, because hey offer servces, whch are mperfec subsues o servces offered by oher workers. There s a connuum of monopolscally compeve unons ndexed over he same range as households h [,] whch ac as wage seers for he dfferenaed labour servces. In a monopolsc labour marke he elascy of subsuon beween dfferen ypes of labour deermnes he mark-up of wages over he equlbrum wage. Ths elascy s defned by (6d L W W = θ W θ L W. Now he wage seng rule can be derved akng dervaves of he Lagrangan w.r.. wages. Usng symmery: W = W and neglecng second order erms allows us o formulae a wage W seng rule n erms of wage nflaon π as (7 π w = ( θ ( + γ W w C PC V U w ( W w ( sfw ( C + β π + + PC ( + L, w w ( + mup sfw π C, w wh a wage mark up erm mup = whch goes o zero as he subsuably beween dfferen θ ypes of labour goes o nfny. Households are seng he real ne consumpon wage as a mark up over he value of lesure whch s defned as he margnal uly of lesure dvded by he margnal uly of consumpon.. Ths formulaon generalses he neoclasscal labour supply model along wo dmensons. Frs, because of mperfec subsuably beween dfferen ypes of labour, households can se a consumpon wage whch s above he reservaon wage as deermned by he value of lesure. The magnude of he wage mark up depends on he degree of subsuably beween varees of labour. Second, by nroducng convex wage adusmen coss ( γ w >, workers wan o smooh wage adusmens, akng no accoun curren and fuure expeced labour marke condons. Noce, lke n he goods marke, we assume ha a fracon (-sfw of workers ndex wage nflaon o nflaon n perod -. Ths frs order condon can be reformulaed as a wage seng rule..4 Aggregaon The aggregae of any household specfc varable X h n per capa erms s gven by = h k X X dh = ( slc X + slcx snce households whn each group are dencal. Hence aggregae consumpon s gven by (8a C = ( slc C + slcc k and aggregae employmen s gven by

13 (8b k N = ( slc N + slcn wh N = N = N. k k k k Snce lqudy consraned households do no own fnancal asses we have B = B = K =. F.3 Polcy: We assume ha fscal and moneary polcy s parly rules based and parly dscreonary. Polcy responds o an oupu gap ndcaor of he busness cycle. Conssen wh our producon funcon he oupu gap s gven by (9 (α ucap L YGAP =. ss ss NPART ucap L ( e α where ss L and ss ucap are movng average seady sae employmen rae and capacy ulsaon: ss ucap ss ucap (9a log( ucap = ( ρ log( ucap + ρ log( ucap ss Lss ss Lss (9b log( L = ( ρ log( L + ρ log( L Ths concep of an oupu gap was chosen because we wan o be as close as possble o he sandard pracce of calculang oupu gaps ha s used n fscal survellance n he euro area (see Dens e al. (..3. Fscal Polcy Boh expendure and receps are respondng o busness cycle condons. On he expendure sde we denfy he sysemac response of governmen consumpon, governmen ransfers and governmen nvesmen o he busness cycle. We allow he share of governmen consumpon n GDP PCG log( = log( GSN = gsn PY and he share of governmen nvesmen PCGI log( = log( GISN = gsn PY o respond sysemacally o he busness cycle accordng o he followng rules ( ( Lg Y + g, log( YGAP = gsn = ( gslag gsn + gslag gsn + e Lg Y + g, log( YGAP = gsn = ( gslag gsn + gslag gsn + e G GI Governmen consumpon and governmen nvesmen can emporarly devae from her long run arges n response o flucuaons of he oupu gap. Due o nformaon and mplemenaon 3

14 lags he response may occur wh some delay. Ths feaure s capured by a dsrbued lag of he oupu gap n he reacon funcon. A dscusson abou he acual denfcaon of he number of lags s gven laer n Secon. Concernng he ransfer rule we mpose more nsuonal nformaon. The ransfer sysem n he euro area provdes ncome for unemployed and for pensoners and acs as an auomac sablser. The sae conngen naure of ransfers mples a correlaon wh cyclcal condons, namely he curren employmen gap. The degree of sablsaon s proporonal o he unemploymen benef and penson replacemen rae b U and b P respecvely and we can wre he followng ransfer rule ( TR W L POP W POP L + W POP POP POP POP W W Old L dep = TR TR L L W TR We defne rsn = and rewre he ransfer rule n erms of log devaons of he employmen WL rae from s seady sae level Old L L dep POP TR (3 rsn = rsn + TR log( + ss NPART TR + e W L ( e POP Dscreonary fscal acon s characersed by he varables e g (g=g,gi,tr whch follow g g g g g g auocorrelaed processes e = ρ e + ε, ε ~ N(, σ. Governmen revenues ncome. G R are fnanced by axes on consumpon as well as capal and labour G w c c p (4 R = W L + P C + PY W L ( Followng he OECD esmaes for revenue elasces (van den Noord ( we assume ha consumpon and capal ncome ax follow a lnear scheme, and a progressve labour ncome ax schedule w w TW (5a = Y exp( e w w where measures he average ax rae, w he degree of progressvy and e TW s an auoregressve shock. A smple frs-order Taylor expanson around a zero oupu gap yelds (5b w w w w = + log( YGAP + e TW The governmen budge consran s gven by (6a B = ( + B + PC G + TR R G Tax 4

15 and here s a resdual lump-sum ax (Tax used for conrollng he deb o GDP rao accordng o he followng rule B B (6b ΔTax = + Δ bgad ( bar bgad Y P Y P where bar s he governmen deb arge..3. Cenral bank polcy rule (neres rae rule Moneary polcy s modelled va he followng Taylor rule, whch allows for some smoohness of he neres rae response o he nflaon and oupu gap (7 + = lag * Y M, U T π C T π M π π log( YGAP + ( lag *[ Ex. R + g + / YGAP + e M + ] + ( + Y M, log( YGAP The erm M M M M M M e = ρ e + ε, ε ~ N(, σ and M e capures auocorrelaed dscreonary shocks o moneary polcy gven by T π s he nflaon arge..4 Trade and he curren accoun So far we have only deermned aggregae consumpon, nvesmen and governmen purchases bu no he allocaon of expendure over domesc and foregn goods. In order o faclae aggregaon we assume ha households, he governmen and he corporae secor have dencal preferences across goods used for prvae consumpon (C, publc consumpon (G and l l l nvesmen (I. Le X { C, I, G} be demand of an ndvdual household, nvesor or he governmen, hen her preferences are gven by he followng uly funcon (8a X l σ σ = ω σ l d X + ( ω σ X σ l f σ σ ( σ d l f l where X and X are ndexes of demand across he connuum of dfferenaed goods produced respecvely n he domesc economy and abroad, gven by. (8b τ τ d n τ τ l d l d τ X = xh, d h= n X l f f n = f h= n τ x τ l f τ h τ τ We defne τ o measure he nverse of he me varyng elascy of demand for varey h and assume ha s self sochasc and also allow for some cyclcal varaon. The erm τ s gven by (see eq. (5e 5

16 (8c τ = τ + e τ The elascy of subsuon beween bundles of domesc and foregn goods σ. Thus aggregae mpors are gven by X PC IM (9 IM = ( ω ( C + I + G exp( e PM σ d l X and l f X s where PC and PM s he (uly based consumer prce deflaor and mpor prce deflaor respecvely and e s a perssen AR process: IM (9a e IM IM IM IM IM IM = ρ e + ε, ε ~ N(, σ. We assume smlar demand behavour n he res of he world, herefore expors can be reaed symmercally and are gven by W X X α (α XW ( PC E P W X X α (α EX (3 EX = ( ω ( Y Y exp( e PX where PX and E are expor prces an he nomnal exchange rae, prces (n foregn currency XW (ω XW W ω P (3a PC = PW E and e s a perssen AR shock as for mpors: EX σ X W PC are world consumer (3b e EX EX EX EX EX EX = ρ e + ε, ε ~ N(, σ Prces for expors and mpors are se by domesc and foregn exporers respecvely. The exporer buys goods from domesc producers and sells hem n he foregn (domesc marke. I s assumed ha he exporers are monopolscally compeve n her respecve expor markes. Exporers charge a mark-up over domesc prces (lnear echnology and her prcng s subec o convex adusmen coss. Thus expor prces are gven by X (3a η PX = cxp wh a mark-up facor deermned by X X τx X X X X X (3b η ( τ + e γ [ β ( sfpx π + ( sfpx π π ( π π ] sfpx = PX + Where X e τ follows he AR process: τx τx τx e e τx τx = ρ + ε,, ε ~ N(, σ τx Expors EX nclude nra euro area rade, wh a share (-α X. 6

17 We assume ha monopolsc compeon apples o he foregn frms as well. There s no prcng o marke and mpor prces are gven by X X α α ( spm PM (3 PM = cxw ( E PW P ( PM exp( e spm wh e PM PM PM PM PM PM = ρ e + ε ε ~ N(, σ Expors and mpors ogeher wh neres receps/paymens deermne he evoluon of ne foregn asses (NFA denomnaed n domesc currency. F (33 E NFA = ( + E NFA + PX EX PM IM. Esmaon Our echnologcal assumpons mply ha domesc and foregn GDP and s componens are saonary n growh raes. Our model mples ha varous nomnal raos such as he consumpon o GDP rao (CSN, he nvesmen o GDP rao (ISN, he governmen consumpon o GDP rao (GSN, he governmen nvesmen o GDP rao (GISN, he governmen ransfers o wages rao (TRSN he expor (EXSN and mpor (IMSN 3 share n GDP, he wage share (WSN, he employmen rae (L and he real exchange rae (ER are saonary. Concernng nomnal varables we assume ha he domesc and foregn nflaon arge s a consan. Ths mples ha w F domesc wage nflaon rae ( π, foregn and domesc prce nflaon (π, π raes and F nomnal domesc and foregn neres raes (, are saonary, as well as ceran prce raos, n parcular he relave consumer prce (PC/P and he relave mpor (PM/Pand expor prce (PX/P raos. These varables, ogeher wh he followng exogenous varables: growh of populaon of workng age (g popa, he demographc dependency rao (depra and he echnology I shock o he nvesmen good producon ( U form our nformaon se. World economy seres [ F F, π, g YW ] are consdered as exogenous and are modeled as a VAR( process. To assure saonary of he Y/Y W rao, an equlbrum correcon erm s added o he g YW equaon. Ths nroduces a small feedback of domesc demand no world demand. The model s esmaed on quarerly daa for he euro area over he perod from 98Q o 5Q3, aken from he ECB AWM daa base and updaed wh Eurosa quaerly naonal accouns daabase. The parameers lsed n Table are calbraed and kep consan over he esmaon exercse: 3 Concernng he mpor and expor share we remove a rade negraon rend pror o esmaon. 7

18 TABLE. Calbraed parameers Srucural parameers Seady saes α.54 depra.3 β.996 gsn. δ.5 gsn.5 bgad 4.e-6 UI g.3 bgad 4.e-3 F π, π.5 Bgar.4 popa g.5 τ. Y YW g, g.3 G ρ, rslag UP g = Y α UI g α g.9 ucap ρ.975 ucap POP ρ.98 L.6 p c, w,. α X.5 Oher parameers are deermned accordng o seady sae consrans: a = (-τ *(-α/ksn, deermned n order o assure he seady sae consran UCAP=, where KSN = K / Y * PI / P s he nomnal capal o GDP share. ω s deermned n order o assure he seady sae condon L =. 6 The dynamcal forms of governmen spendng and governmen nvesmen have been denfed by esmang separaely from he res of he model an array of models of he general form: δ + δ n+ δ δ + δ n+ δ b, L + b, L b, nl bk,l + bk,l bk, nl (34 y = u m, u m k, + e a L... a L a L... a L m where L s he lagged operaor. The selecon of he model s hen aken consderng boh he sascs, based on he response error, and nformaon crera. For boh governmen consumpon and nvesmen, he npu s he oupu gap. Ths mpled a wo sep-procedure, where frs he dynamcal srucure was denfed usng a HP-flered oupu gap. The obaned srucure and coeffcens are fed no he DSGE model, whch s esmaed gven he prevously denfed coeffcens. A hs sage, we oban a model based oupu gap whch s agan fed no he separaed denfcaon procedure whch gves he fnal srucure. Ths second sep denfcaon s hen used o defne he pror dsrbuon of he coeffcens n he governmen spendng rules, whch are hen esmaed ogeher wh he oher parameers n he DSGE model. Thus, he esmaed governmen consumpon rule akes he form Y Y G (35 ( gsn gslag gsn gslag gsn YGAP YGAP + e = + + G, log( + G, log( m T R 8

19 The nvesmen rule s gven by Y GI (36 ( gsn gslag gsn gslag gsn YGAP + e GI wh e =. = + + GI, log( GI GI GI ρ e + ε The model parameers are esmaed applyng he Bayesan approach as, e.g., Schorfhede (, Smes and Wouers (3. From he compuaonal pon of vew, he DYNARE oolbox for MATLAB has been appled (Jullard, Pror dsrbuons Exogenous AR shocks have bea dsrbuons for auo-correlaon coeffcens wh pror mean a.85 excep for mark-up shock, moneary shock, nvesmen specfc echnologcal shock, wage ax rule shock, where we se pror mean o.5, where we dd no have any preference beween a perssen shock or a whe nose. Sandard errors have pror gamma dsrbuons, wh pror mean values a.%-.5% for perssen shocks (accounng for dfferen rends n he daa, lke parcpaon rae, labour overhead, drf of echnology and for shocks o rsk prema; % for echnology and nvesmen specfc echnologcal shocks and nomnal GDP shares of governmen consumpon, nvesmen, ransfers; % for mpor/expor shocks; 5% for preference shock and mark-up shocks For fscal parameers, we se a pror around zero for Y Y Y G, and G, + G,, o le he daa drve procyclcal or couner-cyclcal reacon of governmen consumpon o oupu gap. For governmen nvesmen, we se he pror of Y IG, a.5,.e. pro-cyclcal response. For ransfers we se pror mean of L TR a.6, whch roughly corresponds o a benef replacemen rae of abou 4%. For wage ax, we se a pror a.8 for he reacon o oupu gap, followng OECD esmae. Snce no axaon daa are used, s hard o have a clear denfcaon of W n he curren exercse, so pung a pror range around OECD esmae has he meanng of checkng ha a calbraed value around.8 s no reeced from avalable daa on consumpon and governmen expendures. Perssence n he governmen spendng and nvesmen rules has a pror a.85, whle for ransfers hs s se o zero. For prce and wage rgdes we roughly follow Smes and Wouers, bu allowng a wder varaon n he upper bound (pror mean a 3. Capal and labour adusmen coss have smlar prors, whle for nvesmen he pror s smaller (5. Pror consumpon hab s se a.7. Inverse of neremporal elasces have pror gamma dsrbuons wh mean.5 and sandard devaon.5, whle θ has a mean.5 and sandard devaon. The share of lqudy consraned households has a pror a.5, wh sandard devaon., smlarly o Forn e al. (6. The share of forward lookng behavour n hybrd Phllps curves has pror mean a.5 n he range [, ]. 9

20 . Poseror esmaon The draws from he poseror dsrbuon have been obaned by akng 8, runs of Meropols. Convergence of he Markov Chan has been esed by cumulaed means. The shape of he lkelhood a he poseror mode and he Hessan condon number have been also consdered o hghlgh lack of denfcaon for some parameers 4. In Table. we show pror dsrbuons and poseror esmaons of our srucural parameers (see Table A n he annex for esmaes of sandard errors of shocks and AR coeffcens of auocorrelaed shocks and Fgure A for he plos of prors and poseror dsrbuons. TABLE.: Esmaon Resuls Parameer name Pror Poseror dsrb mean Sd mean sd a AE bea Y G Y G, GE bea , GE Y Y G, + G, GSUM bea γ K GAMIE gamma γ I GAMIE gamma γ L GAMLE gamma γ P GAMPE gamma γ PX GAMPXE gamma γ W GAMWE gamma gslag GSLAG bea habc HABE bea habl HABLE bea Y IG, IGE bea gslag IGSLAG bea lag ILAGE bea κ KAPPAE gamma rsk RPREME bea rp RPREMK bea X ω SE bea XW ω SWE X XW ω ω SEDIFF bea sfp SFPE bea sfpx SFPXE bea sfw SFWE bea Only for wo srucural parameers does he lkelhood no domnae he pror, namely for expor prce and wage rgdes ( γ PX and γ W. A smlar lack of denfcaon for γ W seems also presen n Smes and Wouers (3 ( see also Canova and Sala (5 abou denfcaon problems n he Smes and Wouers model and ndsge models n general

21 C σ SIGC gamma X σ SIGEXE gamma σ SIGIME gamma slc SLC bea spm SPM bea θ THETAE gamma π M TINFE bea Y M Y M, TYE bea , TYE bea w TW bea L TR TRE bea dep TR TR3E bea rsn TRSN bea The esmaed fracon of forward lookng prce seng behavour s hgh. The poseror mean for sfp s esmaed a.9, whch mples only 8 percen of frms keep prces fxed a he - level. The esmaed share of lqudy-consraned consumers s.63, whch s hgher han esmaes repored n Coenen and Sraub (5 and Forn e al. (6. Noe ha our esmaes also sugges a sgnfcan degree of hab perssence n consumpon, habc=.93 and an neremporal elascy of subsuon of around.4. The esmaed fscal response parameers are couner-cyclcal for governmen consumpon and ransfers. Governmen consumpon s hghly perssen and responds o he curren change n he Y Y oupu gap (he poseror esmae of he sum G, + G, s n fac no sgnfcanly dfferen from zero. We fnd a negave response of ransfers o he employmen gap ( L TR, correspondng o a benef replacemen rae of abou.4. The nvesmen rule appears procyclcal, wh a hgh degree of perssence. The only parameer relevan for sablsaon polcy on he revenues sde s he degree of progressvy of wage axes. Due o a lack of relable daa on ax raes we esmae hs parameer wh a gh pror dsrbuon around an OECD esmae. The poseror mean of progressvy of he ax sysem w s.77 5, whch s close o our pror based on he OECD esmae of he elascy of ax revenues wh respec o he oupu gap 6. By way of comparson, oher sudes ha have analysed he acual behavour of fscal auhores have manly focused on he overall defc raher han on governmen expendure caagores seperaely. Gal and Pero (3 assess he exen o whch he consrans assocaed wh he Maasrch Treay and he Sably and Growh pac have made fscal polcy n EMU counres more procyclcal. They fnd dscreonary fscal polcy (as measured by he prmary cyclcally adused defc of general governmen was procyclcal n EMU counres before Maasrch and essenally acyclcal afer Maasrch. They also fnd an ncrease n he degree n couner-cyclcaly of non-dscreonary 5 Noe ha he lkelhood does no domnae he pror,.e. no usng axaon daa mples a lack of denfcaon for. The only concluson we can draw s hence ha he OECD pror s no reeced by he daase used for w esmaon. 6 The OECD calculaes an elascy of ncome ax revenue wh respec o he oupu gap of.5 and an elascy of he wage bll w.r.. he gap of.7. Ths mples an elascy of he ax rae w.r.. o oupu gap of.8.

22 fscal polcy (as measured by he dfference beween he oal prmary defc and he cyclcallyadused prmary defc n EMU counres. European Commsson (4, Ch.3 also fnd evdence of a change n he response of he oal prmary budge balance o he oupu gap, wh an nsgnfcan mpac of he cycle on prmary balances before 994 and a sgnfcan posve mpac of he oupu gap on he prmary balance pos 994. In Fgure we show he one sep ahead predcons of he model for he growh raes of GDP Y C I IM EX L ( g, consumpon ( g, nvesmen ( g, mpors and expors ( g and g, labour ( g, G GI TR governmen consumpon ( g, governmen nvesmen ( g, governmen ransfers ( g, as C M X W well as for nflaons (π, π, π, π, wage nflaon ( π, growh rae of nvesmen specfc UI F E echnologcal progress ( g, nomnal neres raes (,, nomnal exchange rae ( g, world F YW nflaon ( π, world GDP ( g. We also show he f of nomnal raos o GDP of consumpon (CSN expor (EXSN, governmen consumpon (GSN, governmen nvesmen (GISN, nvesmen (ISN, ransfers o wages rao (TRSN, he real foregn GDP o domesc GDP rao (YWY as well as he saonary real exchange rae (ER, labour (L, wage share (WS, consumpon o GDP deflaor (PC/P, mpor o GDP deflaor (PM/P, expor o GDP deflaor (PX/P. FIGURE. In-sample one sep ahead predcons of he esmaed model. (Daa are doed lnes; model predcons are sold lnes.. g Y g EX g G g C g IM g GI g I x -3 g L g TR

23 π π X nom log(er.4. π F log(gisn π C π W nom F g YW log(exsn log(isn π M UI x g g E log(csn log(gsn log(l

24 WS log(px /P log(pc /P TRSN log(pm /P log(ywy Model comparsons A que wdely appled mehod o assess he valdy of he esmaed DSGE models s o compare hem wh non-srucural lnear reduced-form models such as VARs or BVARs. In Table., where we compare our base model wh BVAR models (lags o 3 usng Sms and Zha (998 prors. The margnal lkelhood of he BVAR models begns o deerorae afer order 9. Smlarly o oher esmaed DSGE s n he leraure, our base model has a beer margnal lkelhood han BVAR s. Alhough he robusness of hese knds of resuls may depend on dfferen pror assumpons n boh he DSGE and he BVAR, hs s an ndcaon ha our base model has a reasonable emprcal f. TABLE.. Margnal lkelhood BVAR( 858. BVAR( BVAR( BVAR( BVAR( BVAR( BVAR( BVAR(8 87. BVAR( BVAR( 87.3 BVAR( BVAR( BVAR( Base DSGE model 944. We also compared our base model wh a model specfcaons where all he fscal rules are exogenous,.e. where 4

25 G (37a gsn = ( gslag gsn + gslag gsn + e GI (37b ( gsn + e = gslag gsn + gslag gsn Old dep POP (37c rsn = ( rslag rsn + rslag rsn + TR + e W POP w w TW (37d + e = Ths s shown n Table.3, where can be seen ha he base model mproves he margnal lkelhood by more han log-pons wh respec o he model wh exogenous G, GI, TR, TW (esmaes are repored n Annex. Lookng no more deal abou he f (RMSE s of each sngular seres n he wo model specfcaons, can be seen ha he mprovemen of he f n our base model s very sgnfcan, as would be expeced, for he governmen varables G, GI, TR. As far as oher endogenous varables are concerned, he dynamcs of wage nflaon s also much beer descrbed by our base model, whle he oher endogenous varables have mnor changes, C e.g. he f of aggregae consumpon growh ( g and nomnal neres raes for he base model L Y s slghly worse, whle s slghly beer for employmen ( g and oupu ( g growh and consumer prce nflaon ( π. TABLE.3 C Exogenous Base Model G, IG, TR, TW Margnal lkelhood Y rmse g C rmse g I rmse g G rmse g IG rmse g TR rmse g L rmse g W rmse π rmse nom.6.77 rmse π C rmse π M rmse π.4.38 X rmse π E rmse g EX rmse g.4.4 IM rmse g TR

26 3. Assessng he Role of Fscal Polcy We now proceed o nvesgae he role of fscal polcy n sablsng he economy by analysng he mpulse responses and varance decomposon of he esmaed model. We frs look a he effecs of governmen consumpon, nvesmen and ransfer shocks n he model, by comparng he responses of he esmaed model wh hose whou fscal polcy reacons o cyclcal Y Y Y L W condons,.e. when G, = G, = GI, = TR, = =. We also compare he dynamc responses of he man economc varables o srucural shocks n he esmaed model wh hose when he fscal response parameers are se o zero,.e. n a model whou sysemac fscal polcy reacons o cyclcal condons and whou perssence,.e. Y Y Y L W G, = G, = gslag = GI, = gslag = TR, = =. Ths s followed by a drec comparson of he sandard devaons for he man economc varables, as generaed by he model wh and whou acve fscal polcy. 3.. How large are he effecs of governmen consumpon, nvesmen and ransfers shocks? Fgures o 4 show he response o a governmen consumpon, nvesmen and ransfers shock respecvely, for he esmaed model (sold lnes and he model whou acve fscal polcy,.e. Y Y Y L W wh G, = G, = GI, = TR, = =, bu wh he esmaed perssence (doed lnes. The magnude of he shocks s gven by he poseror esmae,.e. we used he full on poseror dsrbuon of srucural parameers and shocks o produce he Bayesan uncerany bounds of IRFs. The governmen consumpon and nvesmen shocks rase governmen spendng as a share of oupu, bu spendng gradually reurns o baselne. We are parcularly neresed n he effec of lqudy consrans on he response of consumpon o hs shock. The second, fourh and ffh panels show he responses of aggregae consumpon C, non lqudy-consraned consumpon C and lqudy-consraned consumpon C k respecvely. Afer a governmen consumpon shock, consumpon of Rcardan households C falls on mpac, bu consumpon of lqudy consraned consumers C k rses as wage ncome ncreases, alhough n laer perods lqudyconsraned consumpon falls below baselne, as he buld-up of deb leads o an ncrease n axes and reduces afer ax ncome. In he model whou fscal polcy reacons (doed lnes aggregae consumpon s also hgher. However, n he esmaed model wh acve fscal polcy, ransfers fall as employmen rses, and he negave mpac of hs on lqudy-consraned consumpon C k means ha aggregae consumpon C now falls 7. The spendng shock crowds-ou prvae nvesmen. The responses of prvae consumpon o a governmen nvesmen shock are broadly smlar, excep ha he esmaed governmen nvesmen rule s pro-cyclcal. 8 7 Expermens show ha only elmnang he reacon of he ransfer rule o he employmen gap would be suffcen o generae a posve response of aggregae consumpon. 8 Noe ha nvesmen s assumed o be non-producve here, as we focus on shor erm sablsaon n hs paper. 6

27 FIG.. IRF s o a governmen consumpon shock. Sold lnes are poseror means and confdence nervals for he esmaed model, whle doed ones are he poseror means whou fscal polcy reacons. x 3 Y 5 x 4 C x 3 I 4 x C x 3 G x 4 L 5 4 x 3 log(ygap k 5 x C x 3 GI x 3 WR 4 5 x 4 π x 4 NTBSN x 3 TR 4 x 3 defc 4 c 4 x π 4 4 7

28 FIGURE 3. IRF s o a governmen nvesmen shock. Sold lnes are poseror means and confdence nervals for he esmaed model, whle doed ones are he poseror means whou fscal polcy reacons x 4 Y 5 x C x 4 C k 5 x C 4 4 x 3 I 3 4 x 4 NTBSN x 4 G.6 GI 5 x 4 TR x 4 L x 4 log(ygap 4 4 x 4 WR x 5 π 4.5 x 3 defc.5 4 c x π 4 4 8

29 FIGURE 4. IRF s o a governmen ransfers shock. Sold lnes are poseror means and confdence nervals for he esmaed model, whle doed ones are he poseror means whou fscal polcy reacons. 5 x 5 Y 5 4 x C x 5 G x 5 L 4 4 x 5 log(ygap x 4 C 4 k 4 x C x 4 GI 4 x 5 WR 4 x 5 π 4 5 x 5 I x 6 NTBSN 4 x 4 TR x 5 defc c x π

30 Fgure 4 shows he responses o a governmen ransfer shock. The ncrease n ransfers rases dsposable ncomes and booss lqudy-consraned consumpon. There s a negave mpac on consumpon of non lqudy-consraned consumers, bu hs s much smaller and aggregae consumpon s posvely affeced by he ransfer shock. Agan, fscal polcy crowds ou prvae nvesmen. Our resuls can be compared o Coenen and Sraub (5. They esmae a DSGE model for he euro area smlar o Smes and Wouers (3, bu nroduce non-rcardan households n he model smlar o our lqudy consraned consumers. For a lower share of non-rcardan households (beween.5 and.37 hey fnd a shor-lved rse n lqudy- consraned consumpon, bu fallng below s seady sae level already afer a few quarers, caused by a rse n lump-sum axes due o he buld up of governmen deb. Forn e al. (6 fnd a posve response of consumpon o boh a governmen purchases and a governmen employmen shock, bu assume no fscal response o cyclcal condons. To assess he mpac of he governmen spendng shocks on oupu n erms of radonal "mulplers", he mpac effec for a percen of governmen spendng shock on GDP s.7 n he frs quarer, fallng o.5 n he fourh quarer. I remans posve for hree o four years, and hen urns negave. Cumulaed over he frs year he mulpler s.6. Ths s somewha smaller han resuls repored n Roeger and n Veld (4 for he European Commsson s global macromodel QUEST, whch shows mulplers for he larges four European counres beween.85 and The esmaed mpac fscal mulpler s whn he range found n emprcal sudes of fscal polcy usng srucural vecor auoregresson (SVAR models. Blanchard and Pero ( appled SVAR mehodology o sudy he effecs of fscal polcy n he US and varous auhors have exended he SVAR mehodology o nclude oher counres. Pero (5 fnds large dfferences n he effecs of fscal polcy, wh he responses of GDP and consumpon havng become weaker over me. Only for he US s he consumpon response found posve and dd he GDP mulpler exceed n he pos 98 perod. 3. Wha s he sablsng power of fscal polcy n he euro area? We now urn o he sablsaon power of fscal polcy n he euro area economy over he perod 98q o 5q3. Our emprcal analyss akes no accoun all shocks ha we denfy n he model. Our sraegy s o perform sochasc smulaons wh values drawn from he emprcal dsrbuon of he esmaed shock processes under alernave fscal polcy rules. The benchmark rules for our analyss are he esmaed ax rule (5 and spendng rules (35-(37. We compare he volaly of he euro area economy o a no sysemac fscal polcy scenaro, where we also exclude he lagged dynamc responses and nomnal governmen consumpon, nvesmen and ransfers are always proporonal o nomnal GDP up o a sochasc shock, and he wage ax rae Y Y Y L W s consan ( = = gslag = = gslag = = G, G, GI, TR, = 9 There he governmen consumpon shock s a weghed average of governmen purchases and wage expendures. Wage expendure shocks have larger effecs on GDP han governmen purchases shocks. Reconclng he consumpon response o a governmen consumpon shock wh evdence from Faas and Mhov ( and Gal e al. (3 s complcaed by he fac ha we do no make he dsncon beween governmen purchases of goods and servces and governmen wage expendure. A dsaggregaon of governmen consumpon may requre a seperae modellng of prvae and publc secor. (see Forn e al (6. 3

31 In order o beer undersand he resuls from hs comparson s useful o look frs a he mpulse response funcons for a ypcal supply and demand shock under he wo alernave fscal polcy regmes. The nex secon llusraes he dfferences for a TFP shock and a shock o world demand. Noce, no only he supply shock bu also he demand shock has permanen oupu and prce effecs, snce he laer s generaed va a permanen shock o world oupu n hs model. 3.. TFP shock Fgure 5 presens he level comparson of he esmaed effec of an orhogonalsed shock o TFP ( ε. The connuous lne ndcaes he esmaed model and he doed lne he model whou U sysemac fscal polcy responses o oupu and employmen gaps. As can be seen from Fgure 5, a posve shock o TFP s assocaed wh an ncrease n governmen consumpon and ransfers. I s well known (see Gal (999 ha wh nomnal rgdes supply shocks lead o a demand exernaly. Because frms lower prces nsuffcenly as a response o a cos-reducng shock, here s a lack of aggregae demand. Ths s ndcaed by a negave oupu gap. Expansonary governmen consumpon parally compensaes for he shorfall n demand. The auomac sablsaon va governmen ransfers work n he same drecon, snce hey respond o he declne n employmen and boos consumpon of lqudy consraned households. In order o hghlgh he role played by nomnal rgdes and fnancal marke frcons s useful o look a he fscal polcy response o a TFP shock and s effec n he unconsraned economy (Fgure 6. Because here s mmedae prce adusmen e. g. real wages rse nsananeously - here s no shorfall of demand as ndcaed by an oupu gap measure whch s praccally zero. Thus here s hardly any acve response of governmen consumpon. Also noce, hough here s a (posve response of ransfers because of a fall n employmen, hs has no sablsng effec on oupu snce Rcardan consumers compleely offse he polcy by ncreased savngs. 3