Procyclical Fiscal Policy and Exchange Rate Regimes

Transcription

1 rocyclical Fiscal olicy and Exchange Rae Regimes Ufuk Devrim Demirel May 25 ABSRAC his paper invesigaes he relaionship beween he cyclical characerisics of fiscal policy and he exchange rae regime in a sicky price small-open-economy environmen where he governmen spending and primary balance are deermined endogenously. I is shown ha for a se of plausible parameer values opimal fiscal policy becomes more procyclical and fiscal discipline becomes harder o mainain as he exchange rae policy ges less flexible if he economy is mainly subjec o demand shocks. More rigid exchange rae policies however encourage fiscal discipline and may imply beer sabilizaion properies compared o flexible inflaion argeing rules if he economy is mainly subjec o cos-push shocks. In addiion o he poliical economy facors ha were sressed in he lieraure qualiaive feaures of he procyclicaliy in fiscal policy as well as capial flows in developing counries can be explained in he proposed framework. Universiy of Virginia Deparmen of Economics 22 Wilson Hall Charloesville Virginia 2294 ( udd2p@virginia.edu phone: (

2 I. Inroducion Cyclical flucuaions have been more exreme for he developing counries and inappropriae macroeconomic policies seem o conribue o his resul. rocyclical fiscal policy is ofen addressed as one of he main sources of macroeconomic insabiliy in he emerging markes. his paper sudies he issue of fiscal discipline and cyclical properies of he fiscal policy in relaion o he exchange rae regime when he governmen expendiures are deermined endogenously. he convenional Keynesian framework advises ha he fiscal policy should be counercyclical: he governmen should increase expendiures and cu axes during he imes of recession. eoclassical approach on he oher hand calls for acyclical fiscal policy since he opimal ax raes implied by hese models are roughly consan. Many empirical sudies have invesigaed he behavior of fiscal policy over he business cycle. Gavin and eroi (997 and Sein e al. (999 conrary o he Keynesian and eoclassical argumens provide evidence for procyclical fiscal policy in Lain American counries. alvi and Vegh (2 presen evidence in a much larger sample of counries and Lane (2 shows ha counries wih volaile oupu and dispersed poliical power are he mos likely o run procyclical policies in his empirical sudy on OECD counries. One srand of he heoreical lieraure has sudied poliical economic explanaions. alvi and Vegh (2 argue ha budge surpluses creae poliical pressures for increased spending. he governmen may find i opimal o run procyclical fiscal policy facing hese pressures. he exen of procyclicaliy will be greaer wih a more volaile ax base. Lane and ornell (999 address he lack of a srong insiuional infrasrucure as he main source of he problem. hey consruc a model in which ineres groups compee wih each oher in order o influence he fiscal policy making process. When he economy lacks a srong insiuional background his compeiion among power blocks may lead o a more-han-proporional increase in he fiscal spending compared o he increase in income 2. ornell and Velasco (998 sudy he implicaions of exchange-rae-based sabilizaions and money-based sabilizaions on fiscal discipline. hey argue (and empirically suppor ha if he policy maker is paien enough moneybased sabilizaions wih endogenously deermined flexible exchange rae managemen provide more fiscal discipline. See Barro (979 Chari and Kehoe (999 2 he Voraciy Effec 2

3 he oher srand of he lieraure emphasizes capial marke imperfecions. Riascos and Vegh (2 consider a seing in which governmen spending is deermined endogenously under wo alernaive scenarios: Complee and incomplee markes. Unlike he complee marke case here is more consumpion volailiy and a larger posiive correlaion beween consumpion and oupu in he incomplee markes case. herefore he seing implies a larger posiive correlaion beween oupu and governmen spending on public goods in he incomplee markes case. Aizenman Gavin and Hausmann (996 argue ha developing counries are forced o raise axes and cu governmen spending during bad imes since hey lose access o he inernaional capial markes. While some of hese sudies focus on he cyclical behavior of governmen spending ohers also consider he ax raes and he primary balance. However here does no seem o be a consensus on he exac definiion of fiscal procyclicaliy. Kaminsky Reinhar and Vegh (24 lay ou a concepual framework ha idenifies he characerisics of a procyclical fiscal policy. In line wih heir argumens we make he following definiion: Fiscal policy is procyclical if i reinforces he business cycle by generaing a negaive or zero correlaion beween he primary surplus and he oupu level. his would be an indicaion of he fac ha he increase in governmen spending exceeds he increase in ax revenues during he good imes. oe ha according o his definiion procyclical governmen spending alone does no necessarily imply procyclical fiscal policy. One needs o consider he behavior of primary balance in order o label a fiscal regime as procyclical. his paper invesigaes he implicaions of moneary policy in general and exchange rae regime in paricular on he cyclical characerisics of governmen expendiures primary surplus and fiscal discipline. Kaminsky e al. (24 documen widespread procyclical policy pracices in a sample of 4 counries and show ha he majoriy of developing counries also seem o pursue procyclical moneary policies ha is hey apparenly conduc he moneary policy in a way ha reinforces he business cycle. In addiion o his capial inflows o hese counries seem o exhibi a procyclical paern as well. herefore a sensible heoreical invesigaion of he issue of fiscal procyclicaliy has o be consisen wih his more general procyclical policy and capial inflow phenomenon. We believe ha our approach is relevan due o his very reason: he proposed moneary and exchange rae policy channels can raionalize he procyclical behavior of fiscal policy as an rimary Surplus ax Revenues Governmen Expendiures (excluding ineres paymens

4 oucome of an opimizing policy framework and can accoun for procyclical capial inflows a he same ime. his sudy oulines a wo-secor small open economy model in which nonradable prices are slow o adjus and he governmen spending is deermined endogenously wih respec o he demand for public goods. he households and he governmen face a counry-specific risk premium in he inernaional capial markes which is negaively correlaed wih heir real ne worh ha is he counry s ne wealh in erms of he domesic final goods. oe ha in his environmen keeping he moneary policy igh and mainaining a srong currency in he face of a negaive shock would be cosly in erms of employmen and oupu and would decrease he real ne worh causing an increase in he counry risk premium. As borrowing becomes more cosly he governmen would be forced o mainain greaer fiscal discipline and if he increase in he risk premium is large enough would find i opimal o run primary surpluses. On he oher hand if he moneary policy responds wih lowering he nominal ineres raes his would alleviae he conracionary effecs of he shock which in urn would imply a smaller increase in he counry risk premium. Consequenly he governmen facing a smaller increase in he cos of borrowing would find i opimal o run smaller primary surpluses wih respec o he case in which he moneary auhoriy chooses o keep he currency srong. oe ha wihin he proposed framework defending he domesic currency wih high ineres raes calls for a procyclical moneary policy sance since i requires o keep he raes high in he face of a negaive shock. Moreover i suggess ha he capial inflow will be cu down o a higher exen since he ineres rae faced in he inernaional capial markes will go up more due o a sharper increase in he risk premium. herefore our approach can explain and raionalize he coexisence of procyclical moneary and fiscal policies as well as procyclical capial inflows. hus he moneary policy and he exchange rae regime may have imporan implicaions on he behavior of fiscal auhoriy and capial accoun in a small-open economy hrough his risk premium channel. We explore hese implicaions in wha follows. Our predicions concerning he cyclical behavior of primary surplus under differen exchange rae regimes apply as well o he behavior of governmen expendiures. If he governmen spending is endogeneized wih he inroducion of public goods one migh expec he public good provision o share a similar paern wih he privae consumpion as long as hey are no perfec subsiues. If he moneary auhoriy decides o mainain a arge level or range for he exchange rae i will be required o give up moneary independence and flexibiliy if i chooses no o impose any conrol measures on capial movemens. his would resul in increased oupu and consumpion variabiliy in he face of various disurbances ha buffe he 4

5 economy. As one can expec a posiive correlaion beween consumpion and oupu loss of moneary auonomy implies ha less flexible exchange rae regimes will as well creae more eviden procyclical behavior in governmen spending. In oher words i will be more difficul o mainain he fiscal discipline over he cycle under a less flexible exchange rae sysem 4. he paper proceeds as follows: Secion-II oulines he heoreical model wih deailed microeconomic foundaions. Secion-III discusses he opimal fiscal policy problem when he moneary policy parameers are perceived by he fiscal auhoriy as given and characerizes he soluion under discreion. Secion-IV provides he soluion and calibraion of he model wih he discussion of he observed paerns. Secion-V concludes. II. he Model he model is of a small open economy wih a represenaive agen and monopolisically compeiive producers in he non-radable secor. he governmen axes he represenaive agen and uses he ax revenues o finance he expendiures on he public goods. II.I Households he economy is populaed by infiniely lived households who maximize he expecaion of a discouned sum of uiliies ha depend on a privae consumpion index a public consumpion index and leisure. references of he represenaive household are given by U s Es β s s θ ξ χ C G L κ ν θ ξ χ ( wih < β < and θ χ > where C and G are privae and public good consumpions which are Cobb-Douglas aggregaes of radable and nonradable commodiy bundles and L is labor ime. We assume ha he represenaive household consumes a coninuum of differeniaed nonradable goods indexed by i []. he privae consumpion aggregae is given by C ( C ( C (2 4 his resul is consisen wih ornell and Velasco (998 5

6 where < < is he radable componen is he non-radable componen and C C ( ( σ σ σ di i C C ( where σ is he elasiciy of subsiuion beween he differeniaed nonradable goods. he consumpion-based home currency price index of he household is given by (4 ( ( ( where he sub-indices for he radable and non-radable good prices are ε σ σ ( ( di i (5 he variable is he foreign price of he radable good in erms of foreign currency and ε is he nominal exchange rae. I is assumed ha he purchasing power pariy holds in he radable secor and. oe ha non-radable sub-index gives he minimum expendiure o purchase one uni of non-radable consumpion index defined by (. Given he cobbdouglas aggregae (2 and prices he allocaion of he individual demand across he radable and non-radable bundles is given by C C C C ( (6 On he oher hand represenaive household allocaes he individual demand for each differeniaed non-radable good in he following way: C i i C ( ( σ (7 Represenaive household s budge consrain a period saes ha is disposable income mus be equal o is spending on goods and services and ne purchases of financial asses: (8 W L Y B i B r B B C Π ( ( ε ε ε 6

7 where B is he dollar-denominaed foreign nominal bond B is he domesic nominal bond holdings r is he foreign nominal ineres rae Y is he endowmen of radable goods W is he nominal wage and is he lump-sum ax in nominal erms. We assume ha households own he firms herefore profis of he monopolisically compeiive firms Π are ransferred o he represenaive household. In each period represenaive household is endowed wih radable goods of amoun Y. I is assumed ha Y is sochasic and exogenously given. More specifically: where Y > and Y A Y (9 ln A ρ ln A µ ( 2 wih < ρ < and µ ~ ( σ. Inernaional capial marke is imperfec and he represenaive household is subjec o a counry risk premium such ha he foreign nominal ineres rae ha households face is sensiive o he r value of counry s real ne worh 5. Households face lower ineres rae in he inernaional capial marke as hey build greaer real ne worh. Following Schmi-Grohe and Uribe (2 we assume he following funcional form for he foreign nominal ineres rae and risk premium: ( r ( r e ψ ( W W ( he consan ψ > measures he elasiciy of he foreign nominal ineres rae 6 and i is assumed ha ( r β. he amoun of ne real worh is denoed by W and he consan W is he seady-sae level of he same variable. e worh measures he ne wealh in erms of counry s final goods. herefore i is defined as follows: ε (2 W ( B f Y Y where f is he ne dollar-denominaed asse posiion of he governmen 7. oe ha ne real worh definiion includes he value of dollar-denominaed 5 his assumpion induces he saionariy of linearized model. 6 Alernaively one can define B as foreign deb in which case we should have ψ <. 7 e foreign asse posiion of he governmen should maer for he household s risk premium since he governmen can always ax away he privae income o pay off he public deb. 7

8 foreign deb as well as he GD in erms of he domesic final goods which are assumed o be composies of radable and non-radable goods. Represenaive household s problem can be described as maximizaion of ( subjec o (8 and (9. Labor marke is perfecly compeiive and households ake he level of public good provision and he level of he ineres rae as given. Firs order condiions of household s maximizaion wih respec o consumpion foreign nominal bonds 8 domesic bonds and labor ime imply: θ ψ ( W W ε θ C E (( r e C ε ( θ θ C E ( i C (4 χ W θ νl C (5 he consumpion Euler equaions ( and (4 sae ha he uiliy derived by saving a uni of domesic currency oday o spend on consumpion omorrow should be equal o he uiliy foregone by no spending i oday. According o he labor supply equaion (5 household works unil he uiliy foregone by supplying an addiional uni of labor ime is equalized o he uiliy gain from he consumpion resuling from he wage income. II.II Firms A coninuum of monopolisically compeiive price seer firms each of which produces a differeniaed non-radable good is disribued on he uni inerval []. roducion echnology for each firm is given by he following Cobb-Douglas producion funcion: Y ( i F α α A ( L( i (6 where A is a produciviy shock L ( i is he labor inpu for he firm i and F is a non-radable fixed facor of producion. he sochasic process for produciviy shock is specified as ln A ρ ln A µ (7 8 I is assumed ha households do no inernalize he fac ha he ineres rae ha hey face in he inernaional capial marke depends on he counry s ne real worh. 8

9 2 where < ρ < and µ ~ ( σ. Since he labor marke is perfecly compeiive firms ake he nominal wage as given. hus cos minimizaion yields: Y ( i W α MC( i L( i (8 where MC is he marginal cos. We assume ha prices are slow o adjus in he non-radable producion secor. hese firms face a downward sloping demand curve given by (7 and se heir prices in a saggered and overlapping fashion such ha he firms wih i [ n] se heir prices for even numbered periods such as 24 where < n <. On he oher hand firms wih i [n] se heir prices for odd numbered periods such as 5 herefore a a given period some of he prices will be pre-deermined and ohers will be se o solve he following problem: max Es ( i s s s β s λ ( ( i s Y ( i W L( i (9 subjec o (7 (6 and (8 where ( i is he newly se price and λ is he s marginal uiliy of income for he represenaive household. oe ha since he firms are owned by households hey discoun profis on he bases of boh he subjecive discoun facor β and he marginal uiliy of income. he firs order condiion of he above problem gives: ( i s s θ σ s θ β ( C Y ( i Es β ( C Y ( i MC( i (2 σ s s s Es s hus he firm ses is conrac price so ha he expeced discouned marginal cos will be equal o he expeced discouned marginal revenue over he period during which he conrac price will hold. oe ha his price is a mark-up over he marginal cos and lim ( σ /( σ. herefore as he σ elasiciy of subsiuion beween he differeniaed non-radable goods approaches o infiniy (perfec compeiion case opimal price approaches o he marginal cos. From his poin on we will drop he index i since all he firms are idenical. Given (5 he evoluion of overall price level in he non-radable secor is governed by he rule 9

10 σ σ σ ( n( ( n( (2 II.III Governmen he governmen seeks o maximize he welfare of he represenaive household. I consiss of wo pars: A fiscal and a moneary auhoriy. II.III.I Fiscal olicy Fiscal governmen axes he household income and finances he expendiures on public goods and ne purchase of foreign asses wih he ax revenues. I is subjec o he following ineremporal budge consrain: G ( ( i B G g ε f B ε r f g (22 where G G ω ω ω ( G ( G ω ω ω ( ω ( ( ω (2 (24 where G G is he effecive composie price level ha he governmen faces is he radable componen and G is he non-radable componen of he ( i g composie public good f is governmen s ne foreign asses and B is he nominal bond issued by he governmen. oe ha he governmen is subjec o he same counry risk premium scheme wih he represenaive household 9. I is also assumed ha he profi of he cenral bank ( g g B B is direcly ransferred o he households in he form of lumpsum ransfer paymens herefore he fiscal auhoriy canno sysemaically rely upon he moneary proceeds as a source of revenue. II.III.II Moneary olicy he moneary auhoriy uses he shor-erm nominal ineres rae as he moneary insrumen. I is assumed ha moneary auhoriy can commi iself o a nominal ineres rae rule which subjec o cerain resricions provides a complee characerizaion of he moneary side of he economy. Moneary policy responds o he changes in domesic inflaion rae oupu gap nominal exchange rae and foreign nominal ineres rae. he nominal ineres rae is se according o he following feedback rule: 9 Unlike he households i is assumed ha he governmen inernalizes he fac ha he ineres rae faced in he inernaional capial marke depends on he counry s ne real worh.

11 ( φ φ2 φ Y ε i ( r (25 Y ε where i is assumed ha φ φ2 φ. he parameer φ helps moneary auhoriy conrol he domesic inflaion he parameer φ 2 gives he degree o which he oupu level is argeed and he parameer φ governs he degree o which he moneary policy desires o conrol he exchange rae movemens. A wide variey of moneary-exchange rae policy rules can be sudied wih his formulaion. However we will no analyze he welfare implicaions of differen moneary policy rules. ha would be beyond he purpose and scope of his paper. We will insead invesigae he implicaions of he exchange rae flexibiliy implied by differen rules on he cyclical behavior of governmen spending primary surplus and capial inflows. In paricular we will consider wo benchmark cases: Flexible domesic inflaion argeing (FI ( φ φ and φ and sric exchange rae argeing (FX ( φ φ > 2 φ > > 2 and. One could consider flexible inflaion argeing as a managed floa since he moneary auhoriy pus posiive weighs on price and exchange rae sabilizaion goals a he same ime. Sric exchange rae argeing in ha respec can be hough of as a fixed exchange rae regime since he moneary auhoriy is only concerned wih exchange rae movemens. II.IV Equilibrium Wheher saggered prices prevail or no he non-radable goods marke will clear in each period. oe ha he composiion of public good index may no necessarily be he same as ha of he privae good index. In oher words i may no have he same non-radable componen. herefore he following marke-clearing condiion should be saisfied in order o close he model: I is a well-known fac ha his ype of feedback rules may lead o emergence of muliple equilibria. In a closed economy seup real indeerminacy may arise if he nominal ineres rae response coefficien o inflaion does no exceed a criical level (See Carlsrom and Fuers (24 2 Woodford (22 Benhabib e al. (2 Dupor (2 Clarida e al. (2. his conclusion is no robus o differen model specificaions and i does no as well go unchanged for he case of an open economy and depends on facors like openness (See Zanna (2 De Fiore and Zheng (2 Here we will no derive a formal characerizaion of he se of parameers ha ensure a unique equilibrium however will use appropriae parameer values ha ensure uniqueness.

12 Y C ω ω ω ω G (26 he domesic bond marke should clear in equilibrium. hus following condiion also has o be saisfied: B g B (27 III. Opimal Fiscal olicy In his secion we consider he opimal policy problem faced by he fiscal policymaker. I is assumed ha he fiscal auhoriy akes he moneary policy as given. In oher words he nominal ineres rae rule given in (2 describes he evoluion of a sae variable from he perspecive of he fiscal policymaker. I is also assumed ha a commimen echnology does no exis so ha he governmen canno bind iself o a paricular sequence of he fiscal policy variables. Below we will formulae an opimal policy problem a la Ramsey under commimen and characerize he equilibrium under discreion as a special case of his general soluion. Ramsey commimen problem can be defined as he problem of finding he appropriae fiscal policy ha is associaed wih he highes possible value of he household life-ime expeced uiliy subjec o he consrains implied by he compeiive raional expecaion equilibrium. Wih nominal price rigidiy and non-sae-coningen governmen deb however i is no possible o reduce he consrains on he Ramsey problem ino a dae- implemenabiliy consrain and a resource consrain ha is required o hold every period as in Lucas and Sokey (98 and Chari e al. (99. herefore we consider he consrains implied by he household maximizaion firm maximizaion corresponding budge consrains and marke clearing condiions sequenially. he relevan problem can be defined as follows: max { C G L B f } U s Es β s s θ ξ χ C G L κ ν θ ξ χ (28 subjec o: (8-(8 and (2-(27 See Schmi-Grohe and Uribe (2 and Correia e al. (24 for a discussion of he circumsances under which he se of implemenable allocaions for he Ramsey policymaker can be reduced ino a single dae- consrain in a sicky-price environmen. 2

13 Ramsey equilibrium is a se of coningen pahs { C } G L B f ogeher wih he sochasic processes{ A } A ha solves problem (25. oe ha consrains ( (4 and (2 involve he expecaions of fuure variables. his makes he maximizaion problem defined in (25 inrinsically non-recursive. on-recursiviy of he problem as spelled ou in (28 is closely linked o he ime inconsisency of he opimal commimen plan 2. he governmen needs o ake ino accoun he fuure expecaions of he privae secor herefore he opimal decision a ime canno be defined as a ime invarian funcion of he sae variables a ime. Ramsey problem can be redefined in a recursive way by inroducing new sae variables and laws of moions regarding hose variables ha capure he dynamics of he promises made by he policymaker which implemen he opimal commimen plan. Marce and Marimon (999 develop a framework which generalizes he sandard Bellman equaion of a dynamic program ino a saddle-pah-funcional-equaion wih he help of new co-sae variables. Applying he same echnique he above problem can be rewrien in a saionary and recursive way by inroducing addiional co-sae variables { λ } i ( in he following way: i s Uc λ U { } { } c ε λ2 min max E 4 s β U λ λ2 λi i k k } { C G L B f } o s i r { (29 (( σ / σ MC λ ( (( σ / σ MC λ Uc A L (( σ σ σ ( ε ( ( n( ( n( 2 ε ( ( r B B Y C ( G ε 4 (( r f f G is i wih { λ } where U c denoes he firs derivaive of he uiliy funcion wih respec o he privae consumpion good. Firs wo rows of he above formulaion include respecively he consrains implied by he ineremporal maximizaion of he households and he profi maximizaion problem of he firms. he hird row includes he definiions of he composie and non- 2 See Kydland and resco (977 (98 Barro and Gordon (98 See he appendix for he formulaion of he saddle-pah-funcional-equaion for our problem.

14 radable price indices. Marke clearing condiions regarding he nominal domesic bonds and he non-radable goods have been incorporaed ino he household and he governmen budge consrains o obain he fourh and he fifh rows of he above Lagrangean. Marce and Marimon (999 shows ha here is a dualiy heorem linking problem (29 wih (28 such ha opimal soluion of problem (28 is given by he soluion of (29 as long as he iniial values of he co-sae variables are se λ is i λ i i o zero ha is { }. oe ha he lagged values of { } ener he ime- reurn funcion as sae variables4. hese variables deermine he value o he planner of commiing o he dae- opimal plan. his plan involves seing he values of he co-sae variables o zero in he iniial period and commiing aferwards o he endogenous evoluion of hese variables. imeinconsisency problem arises a his poin if here does no exis any mechanism ha may guaranee such a behavior for he policymaker. I is on he oher hand echnologically feasible for he planner o se he values of hese variables o zero a each period. his however implies ha governmen ignores he pas commimens and would resul in a sub-opimal policy along he lines of full discreion. Under he assumpion ha he governmen lacks he echnology o commi and he privae consumpion good and he public good have he same radable/non-radable composiion one can solve problem (29 o find he following opimaliy condiion from he perspecive of he fiscal policy maker regarding he public goods 5 : C κg σ ξ ( Since he social cos of providing one uni of public good is equal o ha of a privae good opimal marginal rae of subsiuion beween he wo goods is one. herefore opimal ime-consisen plan equaes he marginal uiliies of he privae and he public good. Likewise one can solve for he governmen s opimal dollar-denominaed foreign asse posiion o find he following opimaliy condiion: f B ( 4 Firs order condiions wih respec o hese variables will give he ineremporal Euler equaions (8 and he price seing equaion (7. 5 Rios-Rull e al. (24 solves for he ime-consisen public expendiure under markov-perfec equilibrium and finds a similar resul for he case of lump-sum axes. 4

15 oe ha exisence of a risk premium ha is responsive o he level of he dollar-denominaed foreign deb allows us o pin down he opimal level of f and link i o he level of B even hough we assume lump-sum axes 6. IV. Soluion he model canno be solved analyically. In order o analyze he model we log-linearize he sysem of equaions given by he firs order condiions budge consrains and marke clearing condiions around a non-sochasic seady-sae. Firs we will find a saionary poin and hen will approximae he dynamics around ha poin using eigenvalue-eigenvecor decomposiion.. IV.I Linearized Model he sysem of log-linearized equaions consiss of (8-(4 and (6-(2. Following Sims (2 he sysem is reorganized as: Γ D C Γ D Ψ Πη δ (2 where D is a ( vecor of log-deviaions of he variables from he seadysae levels η is a ( 2 vecor of innovaions δ is a ( vecor of raional expecaions errors and C is a ( vecor of consans. he vecor D includes he log-deviaions of he variables of ineres. 7 he sysem produces hree unsable roos and exhibis saddle-pah sabiliy for plausible parameer values. he assumpion ha foreign nominal ineres rae is sensiive o he ne asse posiion is essenial for he saionariy of he model. Firs-order approximaion o he exac srucural equaions may no provide sufficien accuracy. Kim and Kim (999 indeed give an example of how he firs-order approximae soluion may imply higher welfare for auarky han perfec risk sharing. On he oher hand Woodford (22 idenifies he condiions under which a firs-order approximaion can remain a reliable mehod for welfare analysis for a large class of economic models. Here our purpose is o sudy he cyclical behavior of he fiscal policy under differen exchange rae regimes when he exac soluion o he opimal ime-consisen 6 See he appendix for he derivaion of hese condiions. 7 he vecor D consis of he log-deviaions from he seady-sae levels of he following variables : C B L ε MC S r i A and G A 5

16 fiscal policy problem is known. hus firs-order linear approximaion is sill an appropriae sraegy o sudy hese dynamics. IV.II Calibraion We mus choose a se of parameer values in order o solve he model by numerical approximaion. We will use he mos common parameer values used in he lieraure. I is assumed ha inverse elasiciy of subsiuion for he privae consumpion good and he public good are θ. 4 and ξ well wihin he range used in he lieraure. Following he sandard esimaes we se a % mark-up. herefore σ. World ineres rae (r is se o be around 6% which makes β. 98. he share of he variable facors of producion (α is se o one implying a consan reurns o scale producion funcion 8. IV.II.I Demand Shock: We compue he responses of he governmen spending o a % posiive produciviy shock in he radable secor under differen exchange rae policies using he above parameerizaion. oe ha since he oupu is assumed o be exogenously given in his secor a posiive produciviy shock in he radable secor acs like a pure demand shifer. Figure.I shows he impulse response funcions of a se of variables under fixed exchange rae policy and flexible inflaion argeing ( FI sands for Flexible Inflaion argeing wih φ φ 7 2 φ. and FX is Fixed Exchange Rae wih φ φ2 φ. 7. As one could predic opimal response of he governmen spending ges larger in magniude as he moneary policy moves from flexible inflaion argeing o sric exchange rae argeing (fixed exchange rae regime. he moneary auhoriy is no allowed o exercise any moneary independence facing a posiive real shock when he exchange rae regime is fixed 9. herefore since he non-radable prices are sicky a given shock generaes wild flucuaions in oupu and consumpion. If he moneary auhoriy chooses o increase he nominal ineres rae in he face of a posiive real shock his would end o cu he aggregae demand hrough he ineremporal subsiuion channel. I would however lead o a real exchange rae depreciaion and boos he demand for domesic non-radable 8 he remaining parameer values are se as follows: ψ. 27 χ.. 7 η. 7 ν κ ρ. 9 ρ Since here are no capial conrols in he model moneary independence and fixed exchange rae regime canno be mainained a he same ime. 6

17 goods. Wih he specified parameerizaion he ineremporal subsiuion affec dominaes he real exchange rae effec and leads o milder flucuaions in oupu and consumpion as he moneary auhoriy moves from fixed exchange rae regime o a counercyclical moneary policy implied by flexible inflaion argeing. he marginal uiliies of privae and public good consumpions should be equal on an equilibrium pah. hus he responses of he consumpion and governmen spending will be similar. he response of he primary surplus o a posiive shock is negaive which demonsraes he procyclical characer of he fiscal policy for he chosen parameer values. ax revenues canno be increased enough o compensae for he increased governmen spending during hese imes. he negaive correlaion beween he primary surplus and he oupu is due o he increase in spending moive of he governmen during he good imes. On he oher hand he response ges larger in magniude (and he policy ges more procyclical as he exchange rae regime becomes less flexible. oe he elevaed negaive response of he real exchange rae in he case when he moneary policy remains unresponsive o he shock o sabilize he exchange rae 2. his encourages he governmen o increase he spending more and run larger budge deficis and allows i o ake advanage of he lower cos of borrowing. As he domesic borrowing (or dissaving worsens he foreign asse posiion o a higher exen capial inflow becomes more procyclical ogeher wih he moneary policy. Lasly noice ha FI generaes a larger exchange rae response a he same ime sabilizes he domesic non-radable price level. Wih he specified parameer values he linearized sysem is used o compue he second momens of he variables of ineres. able.i provides he covariances beween he oupu and hese variables under hree differen exchange rae policy scenarios (varying from perfecly fixed o more flexible. Increased flexibiliy in he exchange rae policy is associaed wih lower consumpion variabiliy and lower posiive covariance beween he oupu and he governmen spending. On he oher hand more flexible exchange rae regimes lead o smaller 2 he real ineres rae in his conex refers o he rae ha he households and he governmen face in he inernaional capial markes. 7

18 Figure.I : Demand Shock.25.2 FX FI 2 x - FX FI Governmen Spending rimary Surplus -. FX FI -. FX FI Dollar-denominaed Asses Real Ineres Rae -.2 FX FI.2.5 FX FI ominal Exchange Rae Domesic Inflaion 8

19 negaive covariances beween he oupu level and he primary surplus. able.i Covariances wih Oupu Moneary olicy G S Bf C FX FI able.ii Volailiies (Sandard Deviaions Moneary olicy C G Y FX FI oe he considerable increase in he level of aggregae volailiy when he moneary auhoriy s unique concern is specified as exchange rae sabiliy. When he economy is mainly hi by demand shocks (FX exhibis poor sabilizaion properies which are consisen wih he procyclical naure of he policy. IV.II.II roduciviy Shock In his secion we compue he dynamic responses when he economy is hi by domesic produciviy shocks. We consider a % posiive shock o he echnology parameer in he non-radable secor. Before proceeding o he discussion of he observed paerns we should emphasize he poin ha he domesic produciviy shock acs like a supply shifer under he benchmark parameerizaion 2 ha is produciviy shocks in he non-radable secor exhibis he characerisics of a cos-push disurbance. I is well-known 2 oe ha he oupu and he price level move in he opposie direcion. 9

20 Figure.II: Domesic roduciviy Shock.5.4 FX FI 5 x -4 FX FI Governmen Spending 2 x FX FI Dollar-denominaed Asses rimary Surplus x FX FI Real Ineres Rae.4. FX FI -. FX FI ominal Exchange Rae Domesic Inflaion 2

21 ha when he disurbances are mainly characerized by cos-push shocks here exiss a rade-off beween price and oupu variabiliy 22. Moneary policies ha aim o sabilize he price level in such an environmen may lead o excessive oupu volailiy. herefore hese rules by argeing he inflaion rae do no necessarily imply counercyclical moneary policy responses. In fac hey end o be procyclical since due o he menioned rade-off hey reinforce he oupu movemens when he economy is hi by such cos-push shocks. hus conrary o he case of he demand shock fixed exchange rae regime proves o be more counercyclical compared o flexible inflaion argeing when he economy is hi by a domesic produciviy shock. Figure.II demonsraes he impulse responses of he variables of ineres. Like he previous case he improvemen in counry risk premium lowers he foreign nominal ineres rae (which is referred o as he real ineres rae and encourages spending by providing a lower cos of borrowing. In urn dollardenominaed asses respond negaively implying procyclical capial flows. On he oher hand unlike case of he demand shock as he moneary policy moves from flexible inflaion argeing o a fixed exchange rae regime fiscal policy and capial inflows become less procyclical and can even become counercyclical. his paern poins ou o he previously saed fac ha when he moneary auhoriy faces a rade-off beween price and oupu variabiliy a fixed exchange rae regime implies a more counercyclical moneary policy sance compared o flexible inflaion argeing. able.iii Covariances wih Oupu Moneary olicy G S Bf C FX FI able.iv Volailiies (Sandard Deviaions Moneary olicy C G Y FX FI See Clarida e al. (999 2

22 Second momens of he variables of ineres are compued and repored in ables III and IV. hey confirm he paern observed in he impulse response funcions and are in line wih he above argumens. oe ha his ime (FX delivers beer sabilizaion resuls compared o (FI. IV.III Discussion he main implicaions of he model are due o he imperfecness of inernaional capial markes and o he behavior of risk premium ha he households and he governmen face. aure of he relaionship beween he moneary policy and he cyclical characerisics of fiscal policy depends on he characerisics of disurbances ha buffe he economy. If he uncerainy is mainly due o demand shocks loss of independence in moneary policy inroduced by less flexible exchange rae sysems makes i more difficul o sabilize he oupu and he consumpion demand for he privae and he public goods. As long as he governmen expendiure on public goods and public deb are deermined by an opimizing governmen one can expec increased difficuly in susaining he fiscal discipline over he cycle. he governmen would be emped o increase he expendiure and run budge deficis during he good imes when i faces lower risk premium. Moneary policy a his poin deermines he exen o which he risk premium will be allowed o change. When a posiive demand shock his (FX will ie he hands of he moneary auhoriy and risk premium will decrease dramaically leading o a sharp decline in he cos of borrowing. his will be followed by a boos in privae and public spending accompanied wih a governmen budge defici and an increase in capial inflow in he form of shor-erm foreign borrowing. In he case of a posiive produciviy shock which acs like a supply shifer under he benchmark parameerizaion if he moneary policy ries o mainain price sabiliy by lowering ineres raes his would furher increase he oupu gap. his makes a fixed exchange rae regime counercyclical herefore he predicions of he model when his ype of shocks dominae are he opposie of hose relevan o he case of demand shock. In his case he economy will experience he procyclical fiscal policy and capial inflow phenomenon under he flexible inflaion argeing scenario which ends o reinforce he business cycle. V. Conclusion he conduc of he fiscal policy over he business cycle and he issues of procyclicaliy and fiscal discipline has recenly araced increased amoun of 22

23 aenion. As a conribuion o he lieraure which has mainly focused on he poliical economy issues his paper argues ha less flexible exchange rae regimes and igher moneary policies may lead o procyclicaliy in governmen spending and primary surplus and make i harder o mainain he fiscal discipline for an opimizing benevolen governmen if he economy is mainly subjec o demand shocks. More rigid exchange rae regimes imply greaer fiscal discipline in he same sense if he economy is mainly subjec o cos-push disurbances. he implicaions of he model are also consisen wih he observed capial flow dynamics in he developing counries. his sudy does no invesigae he opimal moneary policy in relaion o he fiscal policy however i akes he moneary policy scheme as given and sudies is implicaions. he resuls offer a moneary policy channel o explain procyclical fiscal policy and capial flows. 2

24 AEDIX A.I: Fully recursive formulaion of he policy problem: he corresponding saddle-pah-funcional-equaion of he lagrangean described in (29 is given by: { } { } [ ] { } ( ( max min ( 4 s W E W k k i i Λ Ω Ω Λ Ψ Ω β λ subjec o ln ln A A µ ρ ( ~ 2 σ µ ln ln A A µ ρ ( ~ 2 σ µ { } i i λ where: { } { } ]' [ 4 i i i i B f L G C Λ λ { } ]' [ i i i A A B f ε λ Ω Ω Λ Ψ 2 2 ( c c r U i U U λ λ ε λ λ ( ( ( / (( / (( c MC MC L A U λ σ σ λ σ σ ( ( ( ( ( ( 2 σ σ σ ε n n ( G C Y B B r ( ( ε ( G f f r 4 ( ε and denoes he hisory of he economy unil he period-. Afer he envelope-heorem condiions are applied he above problem leads o he same firs-order-condiions wih he problem (29. One can use boh approaches for he analysis of he opimal policy. s 24

25 A.II: Opimal provision of public goods and governmen deb under discreion: I is assumed ha he incumben governmen aaches zero value o prior commimens. herefore given ha { } i i λ he firs order condiions of problem (29 wih respec o consumpion governmen spending axes and dollar-denominaed privae and public asses reduce o: (( (( : 4 c c c f f r B B r U C (( (( : 4 G G G f f r B B r U G ( ( ( : db r d E B β ( ( ( : df r d E f β 4 : where ε. Assuming ha privae and public goods have he same nonradable componen (26 implies: ( G C L A Hence. Given his firs wo equaions and he las equaion give ( and ineremporal equaions imply: G C ( ( df r d db r d which gives (. 25

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