Discussion of Forni and Pisanis Expansionary Fiscal Policy

Discussion of Forni and Pisani’s “Expansionary Fiscal Policy and the Trade Balance: Evidence from a Bayesian DSGE model for the euro area” by Giancarlo Corsetti (European University Institute and CEPR) 2 nd BANK OF ITALY CONFERENCE ON MACRO MODELING IN THE POLICY ENVIRONMENT Banca d’Italia 30 June-1 July, 2009, Rome, Italy This information is confidential and was prepared by Bain & Company solely for the use of our client; it is not to be relied on by any 3 rd party without Bain's prior written consent.

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. 2

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! 3

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) 4

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: 5

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

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) 7

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 8

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! 9

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 Þ 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 10

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 short real 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 11

Exogenous spending shocks/or no reversal 12

Endogenous fiscal policy: reversals 13

Spending reversals: flex price 14

Spending reversals: nominal rigidities 15

Including hand-to-mouth consumers 16

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 17

Matching impulse responses (US) 18

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! 19

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 20

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 21