fiscal stimulus in a monetary union: evidence from us ...mkredler/readgr/micoonnakamura... ·...

Fiscal Stimulus in a Monetary Union:Evidence from US Regions (2014)

Nakamura, E. and Steinsson, J.

American Economic Review

(Department of Economics) Reading Group UC3M 1/ 21

Main Contribution

1 Estimate the effect of a relative change in government spending betweentwo different regions on the relative change on output. They call this effectthe open economy relative multiplier

2 Develop a theoretical framework for interpreting how it relates to the closedeconomy multiplier

3 Show that open economy relative multiplier is a better diagnostic tool indistinguishing among alternative macroeconomic models.

Closed economy multipliers is highly sensitive to how monetary and taxpolicy are modelled.


Empirical Analysis. Open Economy Multiplier

1 Data

Military procurement forms from US Department of Defense

Other macroeconomic variables at the state level: GDP, inflation,employment, population.

Sample period: 1996-2009

2 Empirical Specification

Yit − Yit−2Yit−2

= αi + γt + βGit −Git−2

Yit−2+ εit

where:

Yit is output per capita in region/state i in year t

Git is military spending per capita in region/state i in year t

β is the open economy multiplier


Empirical Analysis. Open Economy Multiplier

1 Identification strategy: IV

Use total military spending interacted with state/region dummy as aninstrument for regional/state military spending

Identifying assumption relies on two facts

Variation in military spending depends on geopolitical events

Military spending in some states is systematically higher than in otherstates


1 Potential pitfalls

Can we consider US regions as small open economies?

Subcontracting military contracts to firms. Is military procurement dataindicative of the timing and magnitude of regional military spending?


Empirical Analysis. Results

1 Baseline estimates of the Open Economy Relative Multiplier

2 Extensions

1 Estimated multipliers are robust to adding additional controls

2 They are also robust to using an alternative instrument

3 They are sensitive to the state of the economy


Theoretical Model. Basic description

1 Two regions that belong to a fiscal and monetary union: Home andForeign

2 Total population is normalized to 1. Home population: n

3 Household preferences, market structure and firm behavior is the same inboth regions


Theoretical Model

1 Households

The home region has a continuum of households types indexed by x.Home households maximize their utility:

E0

∞∑t=0

βtu(Ct, Lt(x))

where

Ct =

[φ

1η

HCη

η−1

H,t + φ1η

FCη

η−1

F,t

] ηη−1

CH,t =

[∫ 1

0

ch,t(z)θ−1θ dz

] θθ−1

and CF,t =

[∫ 1

0

cf,t(z)θ−1θ

] θθ−1

If φh > n, household preferences are biased towards home produced goods


Theoretical Model

Households have access to complete financial markets and face a budgetconstraint given by:

PtCt + Et [Mt,t+1Bt,t+1(x)] ≤ Bt(x) + (1− τt)Wt(x)Lt(x) +

∫ 1

0

Ξht(z)dz − Tt

Households face a decision in each period about:

How much to spend on consumption

How many hours of labor to supply

How much to consume of each differentiated good produced

What portfolio of assets to purchase


Theoretical Model

Households’ optimal choices:

uc(Ct, Lt(x)) = βjPtPt+j

1

Mt,t+juc(Ct+j , Lt+j(x)) ∀j > 0 (1)

ul(Ct, Lt(x)) =Wt

Pt(1− τt)uc(Ct, Lt(x)) (2)

(Department of Economics) Reading Group UC3M 10 / 21

Theoretical Model

Households also choose to minimize the cost of attaining the level ofconsumption Ct. This implies the following demand curves:

CH,t = φHCt

(PH,tPt

)−ηand CF,t = φFCt

(PF,tPt

)−ηch,t(z) = CH,t

(ph,t(z)

PH,t

)−θand cf,t(z) = CF,t

(pf,t(z)

PF,t

)−θwhere

PH,t =

[∫ 1

0

ph,t(z)θ−1θ dz

] θθ−1

and PF,t =

[∫ 1

0

pf,t(z)θ−1θ

] θθ−1

Pt =

[φ

1η

HPη

η−1

H,t + φ1η

FPη

η−1

F,t

] ηη−1


Theoretical Model

1 Government

Let GH,t denote government spending per capita in the home region.Total government spending in the home region is then nGH,t.Government demand for differentiated goods are:

gh,t(z) = GH,t

(ph,t(z)

PH,t

)−θand gf,t(z) = GF,t

(pf,t(z)

PF,t

)−θThe government levies both labor income and lump-sum taxes to pay forits purchases of goods.


Theoretical Model

1 Firms

There is a continuum of firms indexed by z in the home region. Firm zspecializes in the production of differentiated good z. The productionfunction of firm z is:

yh,t(z) = f(Lt(z))

Each firm belongs to an industry. The goods in industry x are producedusing labor of type x and all firms in industry x change prices at the sametime.

maxEt

∞∑j=0

Mt,t+j [ph,t+j(z)yh,t+j(z)−Wh,t+j(z)Lt+j(z)]

st nCH,t + (1− n)C∗H,t +GH,t

(ph,t(z)

PH,t

)−θ≤ f(Lt(z))

Firm z can reoptimize its price with probability 1− α as in Calvo (1983).


Monetary and Fiscal Policy

1 Monetary Policy

The federal government operates a common monetary policy for the tworegions. This policy consists of the following augmented Taylor-rule:

rt = ρrrt−1 + (1 − ρ)(φππagt + φy y

agt + φg g

agt )

where

πagt = nπH,t + (1 − n)πF,t

yagt = nyH,t + (1 − n)yF,t

gagt = ngH,t + (1 − n)gF,t

2 Fiscal Policy

Government spending shocks are financed completely by lump-sum taxes

Balanced budget tax policy.

nPH,tGH,t + (1 − n)PF,tGF,t = τ

∫Wt(x)Lt(x)dx


Calibration and Preferences

Preferences: Two forms for the utility function

u(Ct, Lt(x)) =C

1− 1σ

t

1− 1σ

− χLt(x)1+1ν

1 + 1ν

u(Ct, Lt(x)) =Ct − χLt(x)1+

1ν /1 + 1

ν )1−1σ

1− 1σ

Degree of price stickiness: α = 0.75 and α = 0

Production function: f(Lt(z)) = Lt(z)α

Home-bias parameter: φH = 0.69

Monetary Policy

“Volcker-Greenspan” policy

“Fixed real-rate” policy

“Fixed nominal-rate” policy


Theoretical Results. Separable Preferences



Price rigidity and policy environment matters so much in determining ef-fects of government spending: difference in the response of the real interestrate to government spending shocks under both settings

The enormous variation in possible values for the closed economy aggregatemultiplier depending on the policy environment represents a problem forpolicy recommendation.



The open economy relative multiplier is sensitive to:

Economic fundamentals (e.g., the degree of price rigidity)

Region-specific policies (e.g., the persistence of the regional governmentspending shock)

The relative monetary policy between the two regions is fixed regardlessof the stance of aggregate economy.

The open economy relative multiplier is akin to the closed economy aggregatemultiplier for a relatively accommodative aggregate monetary policy


Theoretical Results. GHH Preferences

Intuition: In response to a government spending shock, households mustwork more to produce the additional output, which rises consumptiondemand as Ct and Lt are complements... which further boosts output.

Introduction of GHH preferences does not generically increase the closedeconomy aggregate multiplier


Conclusion

The open economy relative multiplier is a sharp diagnostic tool in distin-guishing among alternative macroeconomic models.

The closed economy aggregate multiplier is highly sensitive to how aggres-sively monetary and tax policy “lean against the wind” in response to agovernment spending shock.


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