Pressing questions and recent debates

1. Discussion ofForni and Pisani’s“Expansionary Fiscal Policy and the Trade Balance: Evidence from a Bayesian DSGE model for the euro area”byGiancarlo Corsetti (European University Institute and CEPR)2nd BANK OF ITALY CONFERENCE ONMACRO MODELING IN THE POLICY ENVIRONMENT Banca d’Italia 30 June-1 July, 2009, Rome, Italy

2. Pressing questions and recent debates • Fiscal policy • Size and sign of the multiplier (under what conditions)? Counterproductive? • Interaction with (conventional and unconventional) monetary policy • International spillovers (demand leakages and exchange rate)? Need for coordination? • But what is the transmission mechanism? Some recent VAR results have revived old debates (consumption multiplier) but also questioned received wisdom on the transmission mechanism: • Exchange rates: evidence of depreciation in response to positive spending shock for the US (and other countries) • (Interest rate) • Twin deficits: for the US, evidence is mixed.

3. What does the paper do • Drawing on Adolfson et al. (2007) and Coenen et al. (2008) use Bayesian open economy DSGE model to assess the quantitative effects of fiscal shocks in the euro area vis-à-vis a (relatively more closed) foreign region (with no spillovers from the home region) • Model is rich on the fiscal side (spending, taxes), and accounts for financial frictions including ‘hand-to-mouth consumers’ • focus on two key dimensions: trade balance and international prices (real exchange rates) • Preliminary, yet nice job!

4. Main results • Adds to skepticism on fiscal stabilization • Output multiplier almost never above one • Investment is crowded out in response to spending and transfers shocks, although is mildly crowded in by temporary reduction in taxes • Consumption multiplier are negative in response to temporary hikes of spending on final goods and taxes on final goods; contained if temporary public transfers • consumption response is strong in response to temporary reduction in labour and consumption taxes => Stress on the need for a sharper understanding of transmission (more later) • Specific contribution to debate • Find twin deficits for spending and transfers • Terms of trade appreciate in response to shocks to spending, transfers, capital income taxes (depreciates with cuts in wage and consumption taxes)

5. Focus of my comments: Exchange Rates • I focus on exchange rates. First some evidence. I draw from ongoing work with Gernot Mueller and Andre Meier. • VAR evidence on the response of Spending shocks (augmented Blanchard-Perotti) for the US:

6. More evidence • VAR evidence on the response of Spending shock for a sample of OECD countries (annual data)

7. What is at stake? Theory Which model predicts a real exchange rate (terms of trade) depreciation in response to spending shocks? • Not a new issue: dubbed embarrassing failure of the Mundell Fleming model, by e.g. Dornbusch 1980 • Should we amend the standard GE models? • F. Bilbiie; T. Monacelli and R. Perotti (among others) stress complementarity between consumption and employment. • M. Ravn, S. Schmidt-Grohe and M. Uribe emphasize ‘deep habits’ in government consumption. • Should we rethink the way we model fiscal policy? • Joint work with A. Meier and G. Mueller: stress on medium-term fiscal framework (spending reversals)

8. What is at stake? Empirics • Is depreciation specific to the US (UK, Canada and Australia, or to our sample average)? • Beetsma, Giuliodori and Klaassen report real appreciation for European countries • CMM provide some evidence that the transmission of spending is associated with appreciation under fixed exchange rates • Is depreciation a by-product of mis-specification? • However, depreciation seems to be detected also using Ramey’s approach to identification

9. A key question • Can (estimated) DSGE models like the one in the paper shed light on the above issues, both theoretically and empirically? • The model imposes lots of structure on the data. The question is whether it is given a change to let the data ‘pick the winner’ among alternative transmission mechanisms • In the specification proposed in the draft, transmission is textbook. In response to spending and transfer shocks: • Consumption by ricardian households is crowded out • Non-ricardian consume more but not enough to drive aggregate consumption up • Why? The standard answer is ‘wealth effects’. • But note that ricardian consumption rises in response to temporary cuts in consumption and wage taxes!

10. A theoretical reconsideration • In present discount value, the change in the tax burden due to the assumed temporary increase in spending and transfer is minuscule (zero in the tax experiments) • What matters is the change in the intertemporal price of consumption and investment • Consumption euler equation: Change in the real return on a very long-term zero coupon bond • With ricardian agent and a high degree of risk sharing, for a given the foreign monetary stance, this is mirrored by the rate of depreciation • consumption, long real rate, real exchange rate • In Figures 2-5 of the paper, appreciation is mirrored by a fall in ricardians’ consumption • Interplay between fiscal shocks and asset prices

11. Spending reversals Let’s play the same theoretical tune in a different way • As an empirically promising instance, embed in the model endogenous dynamic correction of current deficits (actually in the paper, eqs. 19-21) • Mix of cuts in spending (below trend) and rise in taxes (debt sensitivity of spending and taxes) If current spending shocks are partially reversed over time • Anticipation of future spending cuts tends to lower future shortreal interest rates • If prices are flexible, current long real rate rises nonetheless: consumption of ricardian households fall • With nominal rigidities, under a Taylor rule larger adjustment in output: current long real rate may fall: consumption of ricardian households rise

12. Exogenous spending shocks/or no reversal

13. Endogenous fiscal policy: reversals

14. Spending reversals: flex price

15. Spending reversals: nominal rigidities

16. Including hand-to-mouth consumers

17. Taking stocks • Explore more the issue of endogenous debt correction dynamics • There is empirical evidence on debt sensitivity of spending (fiscal rule) • For the US, one can estimate coefficients between -.02 and -.03 • The model does pick this up for the euro area. But effect is swamped by autoregressive coefficient

18. Matching impulse responses (US)

19. More to be done (policy and theory) • Endogenous dynamic of budget (tax and spending) policy has direct bearing on policy • Addresses issues raised by zero bound (see Christiano Eichenbaum and Rebelo; Eggertsson) • The model could be extended along other lines • Non separability (Bilbiie, Monacelli-Perotti effects) • Deep habits • Report long rates!

20. Only a word on twin deficit/divergence • Difficult issue raised by Kim and Roubini. Once again: • Faulty theory? • Faulty empirical specification? • Once again, as is the model is geared towards generating twin deficits

21. Conclusion • Authors have setup a very good framework to address key issues in the current debate on fiscal policy • Results so far suggest that textbook model of fiscal transmission can somehow frame the data for the euro area • But what is the measure of success? • Yet the model could do much more --- embed alternative transmission channels debated by recent literature • Looking forward to see future versions of it