Fiscal Volatility Shocks and Economic Activity

Transcription

1 Fiscal Volatility Shocks and Economic Activity Jesús Fernández-Villaverde, Pablo Guerrón Quintana, Keith Kuester, Juan Rubio Ramírez University of Pennsylvania March 2, 216 FV-G-K-R Fiscal Volatility 1 / 45

2 Motivation: policymakers travails From 21 to 213, many policymakers and observers saw the U.S. economy as buffeted by larger-than-usual uncertainty about fiscal policy. There was little consensus among policymakers about the fiscal mix and timing going forward. Ben Bernanke [July 18, 212]: The recovery in the United States continues to be held back by a number of other headwinds, including still-tight borrowing conditions for some businesses and households, and as I will discuss in more detail shortly the restraining effects of fiscal policy and fiscal uncertainty. FV-G-K-R Fiscal Volatility 2 / 45

3 Motivation: electoral history 8 patterns of party control at the Federal level (combination of President-Senate-House). The 6 elections between 24 and 214 have produced 5 out of these 8 patterns. Tie with and for the highest electoral instability in U.S. history. Ideological indexes suggest that the electoral instability of and had less severe consequences than electoral instability now. FV-G-K-R Fiscal Volatility 3 / 45

4 Ideological position of members of Congress (DW-Nominate) FV-G-K-R Fiscal Volatility 4 / 45

5 Objective Quantify the effects of fiscal volatility shocks on economic activity. We estimate tax and spending processes for the U.S. with time-variant volatility using a Particle filter and a McMc. We feed the estimated rules into an estimated equilibrium business cycle model of the U.S. economy. We simulate the equilibrium using a third-order perturbation (new formulae for analytic non-linear IRFs). FV-G-K-R Fiscal Volatility 5 / 45

6 Main results I 1. We find a considerable amount of time-varying volatility in all four fiscal instruments. 2. After a fiscal volatility shock, output, consumption, hours, and investment drop on impact and stay low for several quarters. Main transmission mechanism: an endogenous increase in mark-ups. Upward pricing bias due to the shape of the profit function. 3. Fiscal volatility shocks are stagflationary": inflation goes up while output falls. 4. We estimate a CEE-style VAR and an ACEL-style VAR to document that, after a fiscal volatility shock, markups significantly increase. FV-G-K-R Fiscal Volatility 6 / 45

7 Why the stagflation? Steady-state profits: ( P j /P ) 1 ɛ y mc ( Pj /P ) ɛ y Period profits relative price (P j /P) FV-G-K-R Fiscal Volatility 7 / 45

8 Main results II 5. A two-standard deviations fiscal volatility shock has an effect similar to a 3 b.p. innovation in the FFR as estimated by a SVAR. 6. At the ZLB, the effects are much bigger: 1.7 percent fall of output if we are at the ZLB for 8 quarters. 7. Most important channel: larger uncertainty about the future tax rate on capital income. 8. An accommodative monetary policy increases the effect of fiscal volatility shocks. FV-G-K-R Fiscal Volatility 8 / 45

9 How do we quantify fiscal volatility shocks? Volatility is not directly observed. No data (surveys, asset prices...) or very limited (SPF for g, but short horizon (5qtrs)). Instead, we estimate a stochastic volatility process as in Fernández-Villaverde et al. (211). FV-G-K-R Fiscal Volatility 9 / 45

10 Empirical model Fiscal instruments follow: ( ) bt 1 x t = ρ x x t 1 + φ x,y ỹ t 1 + φ x,b + exp(σ x,t )ε x,t y t 1 ( ) (1/2) σ x,t = (1 ρ σx ) σ x + ρ σx σ x,t ρ 2 σ x ηx u x,t x {g, τ c, τ l, τ k }. Fiscal shocks: ε x,t. Volatility shock: u x,t. No direct effect on taxes. FV-G-K-R Fiscal Volatility 1 / 45

11 Data Construct aggregate (average) effective tax rates from NIPA (Mendoza et al., 1994; Leeper et al., 21): consumption, labor and capital income taxes. General government (= federal + state + local). Spending rule: ratio of government expenditures to GDP. Federal debt (held by the public) from St. Louis Fed. Data sample: 197Q1-21Q2. FV-G-K-R Fiscal Volatility 11 / 45

12 Estimation of fiscal rules Instrument by instrument (easily extended). No correlation of shocks (easily extended). Particle filter+bayesian methods. Flat priors. 2, draws from posterior (5, additional burn-in draws) using McMc. 1, particles to perform the evaluation of the likelihood. Estimated Parameters FV-G-K-R Fiscal Volatility 12 / 45

13 Smoothed volatility: tax on capital income FV-G-K-R Fiscal Volatility 13 / 45

14 An age of uncertainty: , I The Washington Post [September 16, 1973]: Is the Nixon administration inclined to favor a tax increase? The authoritative answer last week was: (1) Yes; (2) No; (3) Maybe; (4) It is under consideration." Watergate scandal. George Shultz resigns on May 8, 1974, substituted by William E. Simon. Richard Nixon resigns on August 9, Evidence from Arthur Burns diary. FV-G-K-R Fiscal Volatility 14 / 45

15 An age of uncertainty: , II The New York Times [January 15, 1975]: President Ford has not turned the economy around with his new energy and economic proposals, but at least he has turned himself around." Gerald Ford becomes president: Nixon s pardon erodes his credibility. Constant fights between Nelson Rockefeller, Donald Rumsfeld, and Dick Cheney. Tax increase announced on October 8, After ferocious infighting within the administration, a tax reduction announced on January 16, Continuous changes in Congress. Ford close to veto final tax cut. FV-G-K-R Fiscal Volatility 15 / 45

16 An age of uncertainty: , III The Presidency of Gerald Ford [John Robert Greene]: The new mood in Capitol Hill made any kind of a coalition virtually impossible even for such an experienced legislative hand as Gerald Ford. More so than any other time since 1945, American government was truly divided..." Class of 1974 Congressman. Breakdown of old committee system. Wilbur Mills car stopped on October 9, Al Ullman is less powerful. Humphrey-Javits act about indicative planning. FV-G-K-R Fiscal Volatility 16 / 45

17 The Congressman and the Argentine Firecracker FV-G-K-R Fiscal Volatility 17 / 45

18 Forecast dispersion: tax on capital income FV-G-K-R Fiscal Volatility 18 / 45

19 Relation with other measures of uncertainty How much do we believe our empirical results? Bloom et al. (214) measure uncertainty using news media coverage, tax provisions set to expire, and disagreement among forecasters. Surprisingly high correlation of their uncertainty measure with our smoothed volatilities. For instance, correlation of uncertainty with volatility of capital taxes:.56. FV-G-K-R Fiscal Volatility 19 / 45

20 Key ingredients Representative household. Labor supply flexible, but wages with quadratic adjustment cost. Investment adjustment costs, but flexible utilization margin of capital. Prices with quadratic adjustment cost. Fiscal rules as discussed above+taylor rule for monetary policy. FV-G-K-R Fiscal Volatility 2 / 45

21 Households I Household maximizes: { E β t (c t b h c t 1 ) 1 ω 1 l 1+ϑ } j,t d t ψ 1 ω 1 + ϑ dj t= Intertemporal shock d t : log d t = ρ d log d t 1 + σ d ε dt, ε dt N (, 1) Savings: 1. Invest, i t. 2. Hold government bonds, B t, with nominal gross interest rate R t. FV-G-K-R Fiscal Volatility 21 / 45

22 Households II Budget constraint: (1 + τ c,t )c t + i t + b t + Ω t + 1 AC w j,t dj = ( 1 τl,t ) 1 w j,tl j,t dj + ( 1 τ k,t ) rk,t u t k t 1 + τ k,t δk b t 1 + +b t 1 R t 1 Π t + Ϝ t. Real wage adjustment costs for labor type j: ACj,t w = φ ( ) 2 w wj,t 1 y t 2 w j,t 1 Quadratic cost Calvo. Remember: non-linear solution! We also computed the model with Calvo pricing. FV-G-K-R Fiscal Volatility 22 / 45

23 Households III Labor packer: l t = ( 1 ɛw 1 ɛw lj,t dj ) ɛw ɛw 1 Demand for each type of type of labor: l j,t = ( wj,t w t ) ɛw l t By a zero-profit condition: w t = ( 1 w 1 ɛw j,t ) 1 1 ɛw FV-G-K-R Fiscal Volatility 23 / 45

24 Households IV Capital accumulation: k t = (1 δ(u t )) k t 1 + ( [ ]) it 1 S i t i t 1 where: δ(u t ) = δ + Φ 1 (u t 1) Φ 2(u t 1) 2 Quadratic adjustment cost: S [ it i t 1 ] = κ 2 ( ) 2 it 1 i t 1 which implies S(1) = S (1) = and S (1) = κ. Book value of capital: k b t = (1 δ)k b t 1 + i t FV-G-K-R Fiscal Volatility 24 / 45

25 Firms I Competitive producer of a final good: y t = ( 1 ) ε y ε 1 ε 1 ε it di Buys intermediate goods at price P i,t and charges P t. Demand: Price index: P t = y it = ( 1 ( Pit P t ) ε y t P 1 ε it di ) 1 1 ε FV-G-K-R Fiscal Volatility 25 / 45

26 Firms II Intermediate good producer with market power: y it = A t kit α l1 α it φ A t is neutral productivity: log A t = ρ A log A t 1 + σ A ε At, ε At N (, 1) and ρ A [, 1) Intermediate producer sets prices at cost: AC p i,t = φ p 2 ( ) 2 Pi,t Π y i,t P i,t 1 FV-G-K-R Fiscal Volatility 26 / 45

27 Government Monetary authority follows Taylor rule: R t R = ( Rt 1 R ) 1 φr ( Πt Π ) (1 φr )γ Π ( ) (1 φr )γ y yt e σmξ t y Fiscal authority s budget constraint: b t = b t 1 R t 1 Π t +g t ( c t τ c,t + w t l t τ l,t + r k,t u t k t 1 τ k,t δk b t 1 τ k,t + Ω t ) Transfers: Ω t = Ω + φ Ω,b (b t 1 b) where φ Ω,b >. FV-G-K-R Fiscal Volatility 27 / 45

28 Aggregation and solution Aggregate demand: y t = c t + i t + g t + φ p 2 (Π t Π) 2 y t + φ ( ) 2 w wt 1 y t 2 w t 1 Aggregate supply: y t = A t (u t k t 1 ) α l 1 α t φ Market clearing. Definition of equilibrium is standard. FV-G-K-R Fiscal Volatility 28 / 45

29 Estimation General point: problems for calibration in non-linear models. The Pruned State-Space System for Non-Linear DSGE Models: Theory and Empirical Applications. We use a SMM to estimate most parameters. Parameters for fiscal instruments laws of motion: median of our posteriors. Third-order perturbation solution. Why? Non-linear IRFs. Why? Details of the Estimation FV-G-K-R Fiscal Volatility 29 / 45

30 Experiment ( ) bt 1 x t = ρ x x t 1 + φ x,y ỹ t 1 + φ x,b + exp(σ x,t )ε x,t y t 1 ( ) (1/2) σ x,t = (1 ρ σx ) σ x + ρ σx σ x,t ρ 2 σ x ηx u x,t At time, the economy is hit by a fiscal volatility shock to capital income tax. Taxes are constant today. Two-standard deviation shocks to u k,t. Meant to capture current fiscal outlook. Perotti (27), Bloom (29). FV-G-K-R Fiscal Volatility 3 / 45

31 Fiscal volatility shocks output cons. invest. hours marg. cost inflation (bps) nom. rate (bps) wages FV-G-K-R Fiscal Volatility 31 / 45

32 Fiscal volatility shocks (black solid) vs. 3bps monetary shock (red dots) output cons. invest. hours marg. cost inflation (bps) nom. rate (bps) wages FV-G-K-R Fiscal Volatility 32 / 45

33 VAR evidence: IRFs output consumption investment quarters quarters 15.5 hours quarters quarters 15 nominal rate (bps) quarters markup real wage quarters inflation (bps) quarters quarters quarters capital tax vola FV-G-K-R Fiscal Volatility 33 / 45

34 X: 1 Y: The effect of the ZLB output cons. invest. hours marginal cost inflation (bps) nominal rate (bps) wages FV-G-K-R Fiscal Volatility 34 / 45

35 Monetary policy output cons. invest. hours marg. cost inflation (bps) nom. rate (bps) wages ( R t R = Rt 1 R ) 1 φr ( Πt Π ) (1 φr )γ Π =1.5 ( ) (1 φr )γ y =.5 yt y e σ mξ t FV-G-K-R Fiscal Volatility 35 / 45

36 Degree of nominal rigidities.5.1 output consumption investment hours marginal cost inflation(bps) nominal rate(bps) wages blue: (Calvo) φ p =.1 red: (Calvo) φ w =.1 magenta: (Calvo) φ p =.1 and φ w = FV-G-K-R Fiscal Volatility 36 / 45

37 The role of precautionary price setting output cons. invest. hours marg. cost infl. nom. rate wages FV-G-K-R Fiscal Volatility 37 / 45

38 The future So far, I have dealt with two-sided risk. This may not capture what many observers have in mind: one-sided risk. For instance, taxes will increase, but we do not know why how much. A simple alternative: innovation to shock+volatility shock. A more appealing alternative: one-sided risk. Formally: shocks to skewness. One-Sided Risk and Economic Activity (214). FV-G-K-R Fiscal Volatility 38 / 45

39 One-side risk Stochastic process: where x t = ρx t 1 + (1 ρ)υ t + (1 ρ 2 ) (1/2) e τ t ω t + (1 ρ)e α t ξ 1 t (1 ρ)e β t ξ 2 t υ t = (1 ρ υ )υ + ρ υ υ t 1 + η υ (1 ρ 2 υ) (1/2) ε 1 t τ t = (1 ρ τ )τ + ρ τ τ t 1 + η τ (1 ρ 2 τ ) (1/2) ε 2 t α t = (1 ρ α )α + ρ α α t 1 + η α (1 ρ 2 α) (1/2) ε 3 t β t = (1 ρ β )β + ρ β β t 1 + η β (1 ρ 2 β )(1/2) ε 4 t ω t N (, 1), ξ i t exp (1), ε j t N (, 1) FV-G-K-R Fiscal Volatility 39 / 45

40 Conclusion High fiscal volatility is a concern for policymakers. But, how big are the effects of fiscal volatility shocks? Our simulations indicate that the effect can be important. Key role for monetary policy in propagation. Modeling of political-economic equilibrium that leads to these shocks remains an open issue. FV-G-K-R Fiscal Volatility 4 / 45

41 Estimated parameters ρ x.99 [.975,.999] σ x 6.1 [ 6.27, 5.75] φ x,y.31 [.11,.55] φ x,b.3 [.,.7] ρ σx.31 [.6,.57] η x.94 [.73,1.18] Tax rate on Government Labor Consumption Capital Spending.99 [.981,.999] 7.9 [ 7.34, 6.78].1 [.,.5].6 [.,.2].65 [.8,.91].6 [.31,.93] Notes: The posterior median and a 95% probability interval. Persistent mean-dynamics..97 [.93,.996] 4.96 [ 5.29, 4.66].44 [.4,.19].4 [.,.16].76 [.47,.92].57 [.33,.88] Stochastic volatility is significant and moderately persistent..97 [.948,.992] 6.13 [ 6.49, 5.39].4 [.2,.].8 [.12,.3].93 [.43,.99].43 [.13,1.15] Return FV-G-K-R Fiscal Volatility 41 / 45

42 Estimation I Preferences and consumer β.9945 Estimated. ω 2 Standard choice. ϑ 2 Chetty (211). ψ Estimated. b h.75 CEE (JPE, 25). φ w 4889 ACEL (RED, 211). ɛ 21 ACEL (RED, 211). Cost of utilization and investment Φ From utilization FOC. Φ 2.1 Estimated. κ 3 Estimated. FV-G-K-R Fiscal Volatility 42 / 45

43 Estimation II Firms A 1 Normalization α.36 Standard choice. δ.11 Estimated. φ p Gali and Gertler (JME, 1999). ɛ w 21 ACEL (RED, 211). Monetary policy and lump-sum taxes Π 1.45 Estimated. φ R.6 Estimated. γ Π 1.25 FGR (21). γ y 1/4 FGR (21). Ω -4.3e-2 Follows from gov. budget constraint. φ Ω,b.5 Small number to stabilize debt. b 2.64 Estimated. FV-G-K-R Fiscal Volatility 43 / 45

44 Estimated III Shocks ρ A.95 King and Rebelo (1999). σ A.1 Estimated. ρ d.18 Smets and Wouters (AER, 27). σ d.78 Estimated. σ m.1 Estimated. Parameters for fiscal instruments laws of motion: median of our posteriors. Return FV-G-K-R Fiscal Volatility 44 / 45

45 Decomposing fiscal volatility shocks.1 output cons. invest. hours marg. cost inflation(bps) nominal rate(bps) wages black: benchmark red: volatility shock only on capital income taxes FV-G-K-R Fiscal Volatility 45 / 45