public investment under debt, tax and money financing investment under debt, tax and ... and...

Public Investment under Debt, Tax andMoney Financing

L. Burlon A. Locarno A. Notarpietro M. Pisani

Banca d’Italia

Central Bank Macro Modelling WorkshopBanque de France

Paris, 16-17 November 2017

The views expressed here are those of the authors and should not

be attributed to the Bank of Italy

Goal

I Evaluate the macroeconomic impact on the euro area of anincrease in public investment in infrastructures underalternative assumptions about funding sources (fiscal side)and monetary policy stance

Motivation

I Increase in public spending in infrastructure has been proposedas a way to address weak aggregate demand and low inflation

I IMF (2014), European Commission (2015), OECD (2016)

I Sustain aggregate demand in the short term, expand supplycapacity in the long run

I Exploit exceptionally low levels of borrowing costs (role ofmonetary policy)

I Cross-country coordination of fiscal stimuli may favor bilateralexports

I Cons: lack of fiscal space, implementation delays, inefficiencies

Contribution

I Model-based assessment: calibrated 3-region New KeynesianDSGE model: two euro-area (EA) regions (”Home” and restof EA, ”REA”) and rest of the world (”RW”)

I EA: monetary union, Home and REA share same monetarypolicy and exchange rate

I Fiscal policy is country-specific. Public sector leviesdistortionary taxes, issues debt, consumes and invests ininfrastructure

I Public capital enters production function of domestic goodswith private capital and labor

I Non-standard monetary policy measures (quantitative easing)have real effects via financial market segmentation

Preview of results

I Sizable medium-long term fiscal multipliers (> 1)

I If coupled with non-standard monetary policy (forwardguidance and quantitative easing), fiscal multipliers becomevery large (> 3 at peak), fiscal stimulus is self-financing andinflation increases

I Cross-country coordination enchances expansionary effects

I Funding matters: Debt-financed fiscal stimulus isgrowth-friendly in the short run but not in the long run,compared to tax-financed

I In all cases, efficiency in public investment implementation iscrucial for the stimulus to have sizable real effects

Related literature

I Coenen et al. (2013): impact on EA of European EconomicRecovery Plan (2008)

I Elekdag and Muir (2014): macroeconomic impact of publicinvestment in infrastructure in EA and Germany

I Blanchard et al. (2015): effects of fiscal expansions inEuropean core economies

I Abiad et al. (2016): empirical evidence on public investmenteffectiveness (role of efficiencty and financing)

I DeJong et al. (2017): effectiveness of public investment inthe EU

Road map

I Model setup: most relevant features, calibration

I Simulated scenarios and results

I Conclusions

Model structure: standard building blocks

I World economy: two euro-area (EA) regions (”Home” andrest of EA, ”REA”) and rest of the world (”RW”)

I Each region: final consumption and investment goods,intermediate tradable (T) and nontradable (NT) goods

I T and NT sectors use private capital, labor and public capital

I Nominal price and wage rigidities: forward-looking Phillipscurve

I Monetary policy: standard and non-standard measures(forward guidance, quantitative easing)

I Financial market segmentation allows non-standard monetarypolicy to have real effects

Model setup: fiscal policy

I Fiscal policy is country-specific. Public sector:

I Lump-sum transfers, public consumption, public investment ininfrastructure

I Distortionary taxes on labor income, capital income,consumption

I Public debt stabilized via a fiscal rule that adjusts lump-sumtransfers to achieve desired debt target

I Government budget constraint:

BSG ,t −BS

G ,t−1Rt−1+PL,tBLG ,t −

∞

∑s=1

κs−1BLG ,t−s ≤ PN,tCG ,t +PIG ,t IG ,t +TRt −Tt ,

Model setup: fiscal policyI Public debt is stabilized via lump-sum transfers:

TRt

TRt−1=

(bsG ,t

b̄sG

)−φ1

,

I Public capital accumulation

KG ,t−1 = (1− δG )KG ,t−2 + AIG ,t−1−N ,

where AIG ,t−1−N , with N ≥ 1, is authorized governmentinvestment in period t − 1−N (time-to-build lags).

I Government investment actually implemented at time t is

IG ,t =N−1∑n=0

bnAIG ,t−n

N−1∑n=0

bn = 1

Model setup: public capital in production

I Home intermediate tradable sector: production function ofgeneric firm i :

YT ,t (i) = KPT ,t (i)

α1T LUT ,t (i)α2T LRT ,t (i)

α3T (KG ,t−1)1−α1T−α2T−α3T

I Similar production function holds in the intermediatenontradable sector

I Public capital taken as given by firms

Model setup: financial segmentation

I Following Chen et al. (2012): imperfect substitutabilityamong financial assets, to relax Wallace neutrality

I In each EA region, two types of households:

I Restricted households only invest in domestic long-termsovereign bonds and own share of domestic capital producersdetails

I Unrestricted households have access to multiple financialassets and invest in physical capital (through capitalproducers, alongwith the unrestricted)

I Long-term sovereign bonds are perpetuities payingexponentially decaying coupon (see Woodford 2001) details

I Non-standard monetary policy: purchases by central bank ↓long-term interest rates =⇒ restricted households ↑consumption and investment

Model setup: capital producers

I Capital producers accumulate physical capital by demandingfinal investment goods subject to quadratic adjustment costson investment change

I Rent out capital to the domestic firms

I Maximize profits with respect to capital and investmenttaking prices as given

I Evaluate returns according to a weighted average of restrictedand unrestricted households’ stochastic discount factors(weights are the corresponding population shares)

I Net revenues are rebated (lump-sum) to domestic restrictedand unrestricted households according to their correspondingshares

Model setup: monetary policy

I Standard (Taylor-rule based) monetary policy

(Rt

R̄

)4

=

(Rt−1R̄

)4ρR(

ΠEA,t,t−3Π̄4

)(1−ρR )ρπ(

GDPEA,t

GDPEA,t−1

)(1−ρR )ρGDP

.

I Non-standard monetary policy measures: forward guidance(FG) on policy rate and purchases of EA long-term sovereignbonds

I Home long-term sovereign bonds:∫ nλR

0BLR,t (j

′)dj ′+∫ n

nλR

BLU,t (j)dj + BL

PSPP,t = BLG ,t ,

I A similar condition holds for the REA region

Long-term sovereign bonds market clearing

Unrestricted

Restricted Government

Foreign Households

PSPP

sovereign long-term

Calibration

I Parameters set in line with literature and to match EA greatratios. Home region is a relatively small country (20% of EAGDP)

I Set restricted households’ discount factor to obtain along-short term spread of 1.8pp on sovereign bonds

I Share of restricted households: 0.25 (in Home and REA).Lack of micro-evidence

I Short-term public debt (ratio to GDP): 13% in Home, 8% inREA. Long-term: 120% in Home, 93% in REA. Averageduration: 8 years

I Central bank purchases are proportional to GDP share of eachregion in EA (PSPP follows capital keys of Eurosystemmembers)

Simulated scenarios

1. Home increase in public investment (debt financed).Monetary policy:

I Taylor ruleI 2-year forward guidance (FG)

2. EA-wide increase in public investment. Monetary policy:I Taylor ruleI 2-year forward guidance (FG)I FG + Quantitative easing

3. Alternative forms of financing (EA-wide increase in pub. inv.):

I Distortionary tax-financed increaseI Monetary accommodation

4. Sensitivity analysis: efficiency in public investment increase(no direct supply-side effect, time-to-build)

Home increase in public investment

I Home government increases public investment by 1% of GDPfor 5 years, then gradually back to baseline level

I During fiscal stimulus, fiscal rule not active: after 5th yearlump-sum transfers stabilize public debt

Home increase Home increase+FG1st year LR 1st year LR

HomeGDP 0.7 1.5 0.7 1.5Inflation -0.1 0.0 0.0 0.0Short-term interest rate 0.0 0.0 0.0 0.0Long-term interest rate 0.1 0.1 0.1 0.1Public deficit 1.0 -0.4 1.0 -0.4Public debt -1.5 3.8 -1.6 3.6

REAGDP 0.0 0.0 0.1 0.0

Home public investment and FG: Home variables

10 20 30 400

1

2GDP

FG

No FG

10 20 30 40-0.2

0

0.2Annualized inflation

FG

No FG

10 20 30 40-2

0

2Consumption

FG

No FG

10 20 30 40-2

0

2Private investment

FG

No FG

10 20 30 40-5

0

5Exports

FG

No FG

10 20 30 400

1

2Imports

FG

No FG

10 20 30 400

0.5

1Labor

FG

No FG

10 20 30 400

1

2Real wage

FG

No FG

10 20 30 400

0.01

0.02Policy rate

FG

No FG

10 20 30 40-0.1

0

0.1Euro nominal exchange rate (increase=appr.)

FG

No FG

10 20 30 40-2

0

2Public deficit

FG

No FG

10 20 30 400

0.1

0.2Long-term interest rate

FG

No FG

10 20 30 40-5

0

5Total (ST+LT) public debt

FG

No FG

10 20 30 40-5

0

5Private holdings of long-term debt

FG

No FG

EA increase in public investment

I Increase in public investment (1% of GDP) simultaneouslyimplemented in Home and REA

I Same assumptions as above

EA increase EA increase+FG1st year LR 1st year LR

HomeGDP 0.9 1.7 1.9 1.8Inflation 0.2 0.0 1.1 0.0Short-term interest rate 0.1 -0.1 0.0 -0.1Long-term interest rate 0.1 0.0 0.0 -0.1Public deficit 0.9 -0.5 0.3 -0.3Public debt -2.2 2.4 -3.4 -0.9

Table: EA public investment increase and FG.

EA increase EA increase+FG1st year LR 1st year LR

REAGDP 0.9 1.5 1.8 1.6Inflation 0.2 -0.1 1.3 -0.1Long-term interest rate 0.1 -0.0 0.0 -0.1Public deficit 0.9 -0.5 0.4 -0.3Public debt -1.5 2.8 -2.6 0.4

EA public investment and FG: Home variables

10 20 30 400

2

4GDP

FG

No FG

10 20 30 40-2

0

2Annualized inflation

FG

No FG

10 20 30 400

1

2Consumption

FG

No FG

10 20 30 40-5

0

5Private investment

FG

No FG

10 20 30 400

2

4Exports

FG

No FG

10 20 30 400

2

4Imports

FG

No FG

10 20 30 400

2

4Labor

FG

No FG

10 20 30 400

1

2Real wage

FG

No FG

10 20 30 40-0.5

0

0.5Policy rate

FG

No FG

10 20 30 40-5

0

5Nominal exchange rate (increase=appreciation)

FG

No FG

10 20 30 40-1

0

1Public deficit

FG

No FG

10 20 30 40-0.2

0


FG

No FG

10 20 30 40-5

0


FG

No FG

10 20 30 40-5

0


FG

No FG

EA public investment and FG: REA variables

10 20 30 400

2

4GDP

FG

No FG

10 20 30 40-2

0


FG

No FG

10 20 30 400

1

2Consumption

FG

No FG

10 20 30 40-5

0

5Private investment

FG

No FG

10 20 30 400

2

4Exports

FG

No FG

10 20 30 400

1

2Imports

FG

No FG

10 20 30 400

2

4Labor

FG

No FG

10 20 30 400

1

2Real wage

FG

No FG

10 20 30 40-0.5

0

0.5Interest rate

FG

No FG

10 20 30 40-5

0


FG

No FG

10 20 30 40-1

0

1Public deficit

FG

No FG

10 20 30 40-0.2

0


FG

No FG

10 20 30 40-5

0


FG

No FG

10 20 30 40-5

0


FG

No FG

EA public investment and quantitative easing

I Same assumptions as above, plus quantitative easing (PublicSector Purchase Programme)

I EA’s central bank purchases: euro 180 billion per period forseven quarters (January 2015 Eurosystem PSPP)

I Long-term sovereign bond purchases in Home and REAproportional to corresponding region size as a share of EA

Table: EA public investment, FG, and PSPP

EA increase+FG FG and PSPP1st year LR 1st year LR

HomeGDP 1.9 1.8 3.0 2.6Inflation 1.1 0.1 2.1 -0.1Short-term interest rate 0.0 -0.1 0.0 0.0Long-term interest rate 0.0 -0.1 -0.5 -0.3Public deficit 0.3 -0.3 -0.6 -0.1Public debt -3.4 -0.9 -1.7 -6.7

EA public investment, FG, and PSPP: Home variables

10 20 30 400

2

4GDP

w/o PSPP

with PSPP

10 20 30 40-5

0


w/o PSPP

with PSPP

10 20 30 400

2

4Consumption

w/o PSPP

with PSPP

10 20 30 400

5

10Private investment

w/o PSPP

with PSPP

10 20 30 400

2

4Exports

w/o PSPP

with PSPP

10 20 30 400

5Imports

w/o PSPP

with PSPP

10 20 30 400

5

10Labor

w/o PSPP

with PSPP

10 20 30 40-5

0

5Real wage

w/o PSPP

with PSPP

10 20 30 40-0.5

0

0.5Policy rate

w/o PSPP

with PSPP

10 20 30 40-5

0


w/o PSPP

with PSPP

10 20 30 40-1

0

1Public deficit

w/o PSPP

with PSPP

10 20 30 40-0.5

0


w/o PSPP

with PSPP

10 20 30 40-10

0


w/o PSPP

with PSPP

10 20 30 40-20

-10


w/o PSPP

with PSPP

EA public investment, FG, and PSPP: REA variables

10 20 30 400

2

4GDP

w/o PSPP

with PSPP

10 20 30 40-5

0


w/o PSPP

with PSPP

10 20 30 400

2

4Consumption

w/o PSPP

with PSPP

10 20 30 400

5

10Private investment

w/o PSPP

with PSPP

10 20 30 40-5

0

5Exports

w/o PSPP

with PSPP

10 20 30 400

2

4Imports

w/o PSPP

with PSPP

10 20 30 400

5

10Labor

w/o PSPP

with PSPP

10 20 30 400

1

2Real wage

w/o PSPP

with PSPP

10 20 30 40-0.5

0

0.5Interest rate

w/o PSPP

with PSPP

10 20 30 40-5

0


w/o PSPP

with PSPP

10 20 30 40-1

0

1Public deficit

w/o PSPP

with PSPP

10 20 30 40-0.5

0


w/o PSPP

with PSPP

10 20 30 40-10

0


w/o PSPP

with PSPP

10 20 30 40-20

0


w/o PSPP

with PSPP

EA public investment: distortionary taxes and money

I EA increase in public investment + FG

I Increase in public investment financed by ↑ distortionary taxrates on labor, capital, and consumption

I Increase in taxes lasts for 5 years, then lump-sum transfers areused

I Alternatively: central bank buys and permanently rolls over anamount of sovereign bonds equal to increase in EA publicinvestment

I Additional supply of base money - used by fiscal authorities tobuy additional goods - contributes to keep interest rates low

Table: EA public investment financing: distortionary taxes and money

EA increase+FG Tax increase Money financing1st year LR 1st year LR 1st year LR

HomeGDP 1.9 1.8 1.6 1.9 2.3 2.1Inflation 1.1 -0.0 0.9 -0.1 1.5 0.0Short-term int. 0.0 -0.1 0.0 -0.1 0.0 -0.1Long-term int. 0.0 -0.1 -0.1 -0.1 -0.2 -0.2Public deficit 0.3 -0.3 -0.6 0.0 0.0 -0.3Public debt -3.4 -0.9 -2.6 -3.7 -2.8 -3.6

Sensitivity analysis

I Efficiency in implementing public investment decisions is key

I Lack of efficiency associated with

I no accumulation of public capital (no direct impact of publicinvestment on supply-side)

I or: slow accumulation of public investment (time-to-build,more gradual impact on supply side )

Table: EA public investment and PSPP: no-public capital accumulationand time-to-build

FG and PSPP No acc. of public K Time-to-build1st year LR 1st year LR 1st year LR

HomeGDP 3.0 2.6 1.9 0.5 1.5 2.2Inflation 2.1 -0.1 1.3 0.0 1.5 -0.2Public deficit -0.6 -0.1 -0.1 0.0 -0.9 0.1Public debt -1.7 -6.7 -0.3 -1.5 -0.3 -3.7

Conclusions

I Benefits of fiscal policy cooperation, synergies between fiscaland monetary policy

I Fiscal multiplier can be > 1 and close to 2: large GDP gains,but not enough to reduce debt-to-GDP ratio

I Larger GDP gains with simultaneous fiscal stimulus in wholeEA and monetary policy accommodation

I Monetary policy role is crucial: FG + QE =⇒ fiscalmultiplier > 3 at peak and investment spending isself-financing

I Financing method is relevant: tax-financed stimulus is lesseffective; debt financing more growth-friendly in the short runbut not in the long run

I Effectiveness of fiscal stimulus enhanced if implementationoccurs efficiently and without delays

Model setup: fiscal policy

I The short-term bond is a one-period nominal bond issued inthe domestic bond market that pays the (gross) monetarypolicy interest rate Rt .

I The gross yield to maturity at time t on the long-term bond is

RLt =

1

PLt

+ κ.

Back

Model setup: restricted households

I Restricted households have access only to the market oflong-term sovereign bonds. The budget constraint is

PLt B

LR,t

(j ′)−

∞

∑s=1

κs−1BLR,t−s

(j ′)

(1)

= Πproft

(j ′)+WR,t

(1− τ`

t

) (j ′)LR,t

(j ′)

−Pt (1 + τct )CR,t

(j ′)− ACW

R,t

(j ′)

,

where BLR,t is the amount of long-term sovereign bonds, Πprof

t

is profit from ownership of the Home capital producers. Thelong-term sovereign bonds have price PL,t and are formalizedas perpetuities paying an exponentially decaying couponκ ∈ (0, 1], following Woodford (2001) Back

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