Kiel Institute for World Economics. Capital Mobility and the Effectiveness of Fiscal Policy in Open Economies

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1 Kiel Insiue for World Economics Duesernbrooker Weg Kiel (Germany) Kiel Working Paper No Capial Mobiliy and he Effeciveness of Fiscal Policy in Open Economies by Chrisian Pierdzioch May 2003 The responsibiliy for he conens of he working papers ress wih he auhor, no he Insiue. Since working papers are of a preliminary naure, i may be useful o conac he auhor of a paricular working paper abou resuls or caveas before referring o, or quoing, a paper. Any commens on working papers should be sen direcly o he auhor.

2 Capial Mobiliy and he Effeciveness of Fiscal Policy in Open Economies Chrisian Pierdzioch Kiel Insiue for World Economics, Duesernbrooker Weg 120, Kiel, Germany Absrac This paper uses a dynamic general equilibrium wo-counry opimizing new-open economy macroeconomics model o analyze he consequences of inernaional capial mobiliy for he effeciveness of fiscal policy. Convenional wisdom suggess ha higher capial mobiliy diminishes he effeciveness of fiscal policy. The model laid ou in his paper provides an example ha a higher degree of capial mobiliy can also increase he effeciveness of fiscal policy. This ends o be he case if he sance of moneary policy can be described by means of a simple moneary policy rule. Keywords: Fiscal policy; Capial mobiliy; Financial marke inegraion; Moneary Policy JEL classificaion: F36, F41 Address: Kiel Insiue for World Economics Duesernbrooker Weg Kiel Germany Telephone: Telefax: c.pierdzioch@ifw.uni-kiel.de Acknowledgmens: I wroe par of his paper during a research visi a he Naional Bureau of Economic Research (NBER), Cambridge MA. I graefully acknowledge he hospialiy of he NBER.

3 1 1. Inroducion The globalizaion of financial markes has become one key manifesaion of he increasing world-wide economic inegraion. This process of inegraion has been fosered by he aboliion of legal resricions on cross border capial movemens and by echnological advances ha have lowered informaion and communicaion coss considerably. As a resul, inernaional financial markes have grown rapidly during he pas decades and inernaional capial mobiliy has increased significanly. Because he degree of inernaional capial mobiliy plays a key role for he effecs and he effeciveness of macroeconomic policies, his can have imporan implicaions for economic policy. As regards fiscal policy, he classic conribuions of Fleming (1962) and Mundell (1963) imply ha, in a flexible exchange rae regime, he effeciveness of fiscal policy, as measured by is effec on aggregae oupu, is an inverse funcion of he degree of inernaional capial mobiliy. In he case of wo large inerdependen economies, he Mundell-Fleming model implies ha capial mobiliy gives rise o an exchange-rae induced crowding-ou effec and, hereby, diminishes he effeciveness of fiscal policy in he counry in which i akes place. In he case of a small open economy, he resuls ha can be derived from he Mundell-Fleming model are even sronger. This model suggess ha in a world of perfec capial mobiliy he exchange-rae induced crowding ou effec implies ha fiscal policy has no effecs on oupu a all in a small open economy (see, e.g., Hallwood and MacDonald, 2000). Even hough researchers poined ou ha he implicaions of capial mobiliy for he effeciveness of fiscal policy may be unclear (Greenwood and Kimbrough, 1985), he convenional wisdom derived from he Mundell-Fleming model has been ha capial mobiliy diminishes he effeciveness of fiscal policy in open economies. Recenly, Suherland (1996) and Senay (2000) have shown ha his core resul of he Mundell-Fleming analysis in principle also holds if one uses a micro-founded dynamic

4 2 moneary general equilibrium macroeconomic model o sudy he oupu effecs of fiscal policy in open economies. Using varians of he prooype wo-counry sicky-price 'new-open economy macroeconomics (NOEM) model developed by Obsfeld and Rogoff (1995), hey have derived he resul ha moving from imperfec o perfec capial mobiliy diminishes he effeciveness of fiscal policy. Thus, as in he radiional Mundell-Fleming model, he effeciveness of fiscal policy, as measured in erms of is shor-run effec on oupu, ends o be an inverse funcion of he degree of capial mobiliy. In his paper, I argue ha increasing he degree of capial mobiliy can increase he effeciveness of fiscal policy in a sandard NOEM model if he sance of moneary policy can be described by means of a simple moneary policy rule. This resul shows ha in analyses of he implicaions of capial mobiliy for he effeciveness of fiscal policy he ineracion beween fiscal and moneary policy should be aken ino accoun. To derive his resul, I use a varian of he sandard NOEM model also employed by Suherland (1996). I exend Suherland s model o incorporae a richer specificaion of he moneary policy rule pursued by cenral banks. Suherland uses a purely auoregressive process as a moneary policy rule. The moneary policy rule I add o Suherland s model conains his moneary policy rule as a special case and is general enough so ha I can discuss he implicaions of various oher moneary policy rules for he effeciveness of fiscal policy. I analyze he implicaions of moneary policy rules ha imply ha cenral banks adop a policy of nominal income argeing, a policy of a srong response o inflaion, and a speed limi policy. The laer implies ha cenral banks seek o arge inflaion and oupu growh. These rules have araced much aenion in he recen lieraure on moneary policy rules. See, for example McCallum and Nelson (1999) for an analysis of nominal income argeing and Walsh (forhcoming) for an analysis of speed limi policies.

5 3 I organize he remainder of he paper as follows. In Secion 2, I lay ou he heoreical model. In Secion 3, I use impulse response funcions o analyze he effeciveness of fiscal policy under alernaive assumpions regarding he degree of inernaional capial mobiliy. I also conduc a sensiiviy analysis o sudy how he resuls of my analysis depend upon he specificaion of he moneary policy rule. Furhermore, I show ha capial mobiliy ends o increase he effeciveness of fiscal policy even if I add oher feaures like habi formaion or inflaion ineria in he form of a parially backward-looking price-seing mechanism o he model. In Secion 4, I offer some concluding remarks. 2. The Model The model I sudy in his paper is a varian of he dynamic general equilibrium open economy model developed by Suherland (1996). This model is a naural candidae for analyzing he quesion I address in his paper because i reains he basic srucure of he prooype NOEM model developed by Obsfeld and Rogoff (1995). Though he deails of is specificaion are sill under discussion, heir model has emerged as he new workhorse model in he inernaional macro and finance lieraure. The main difference beween he prooype model advanced by Obsfeld and Rogoff and Suherland's model is ha he laer is buil on he assumpion ha domesic and foreign bonds are imperfec subsiues. This assumpion renders i possible o analyze he implicaions of he degree of capial mobiliy for he effeciveness of macroeconomic policies. I modify Suherland s model in wo respecs. Firs, I add o he model a richer specificaion of he moneary policy rule ha describes he cenral banks policy. Second, as suggesed by he resuls of recen empirical sudies (see, e.g., Fuhrer, 2002), I assume ha households consumpion choices reflec habi formaion. I use he second exension o conduc one of he sensiiviy analyses described in Secion 3.2 below.

6 4 As in he Obsfeld-Rogoff model, he world is made up of wo counries. Each counry is inhabied by infiniely-lived idenical households. The households form raional expecaions and maximize heir expeced lifeime uiliy. In addiion, each counry is populaed by a coninuum of firms. The households in each counry own he respecive domesic firms. The firms sell differeniaed producs in a monopolisically compeiive goods marke. Because each firm has monopoly power on he goods marke, i reas he price i charges for is produc as a choice variable. When changing he price of heir produc, firms have o ake ino accoun ha prices are sicky. As is sandard in he NOEM lieraure, he capial sock is fixed. The only producion facor used by firms is labor. Firms hire labor in a perfecly compeiive labor marke. There is no migraion of labor across counries. 2.1 Households Preferences and Goods Marke Srucure Domesic and foreign households have idenical preferences and maximize heir expeced lifeime uiliy. The expeced lifeime uiliy of a domesic household is defined as U = E s= β s u s, wih 0 <β< 1 being he households subjecive discoun facor. The operaor E denoes expecaions condiional on he informaion se available o he household in period. The period-uiliy funcion, u, is given by u = ( σ / h ( σ σ ε µ ( σ 1) )( / ) 1) / 1 C C + χ( M / P ) /(1 ε) κn / µ 1, (1) where µ > 1, σ > 0, κ>0, ε>0, χ > 0, and he habi formaion parameer lies in he inerval h 0,1). In Eq. (1), C denoes a real consumpion index, N denoes he [ households labor supply, and M / P denoes he end-of-period real money holdings, where

7 5 M denoes domesic nominal money balances and P denoes he aggregae domesic price index defined below. Households hold only he money issued by he cenral bank of he counry in which hey reside (i.e., here is no currency subsiuion). The aggregae consumpion index, C, is defined as a Dixi-Sigliz aggregae over a coninuum of differeniaed, perishable domesic and foreign consumpion goods of oal measure uniy. These goods are sold by domesic and foreign firms in a monopolisically compeiive goods marke and are indexed by consumpion index can be expressed as z on he uni inerval, so ha he aggregae C = 0 1 θ /( θ 1) ( θ 1) / θ c ( z) dz, (2) where θ > 1 and c(z) denoes consumpion of good z. The domesic aggregae price index, P, is defined as he minimum expendiure required o buy one uni of he aggregae consumpion index, C. Assuming ha he law-of-one-price holds for each differeniaed good and denoing he domesic currency price of good ( p z), his price deflaor can be wrien as z by P = 1 1/(1 θ ) 1 1/(1 θ ) 1 θ 1 * 1 θ ( ) n θ p = ( ) + { ( )} z dz 0 p z dz 0 S p z dz, (3) n where n (1 n ) is he number of differeniaed goods made a home (abroad), S denoes he nominal exchange rae defined as he amoun of domesic currency unis required o buy

8 6 one uni of he foreign currency, and p * ( z ) denoes he foreign currency price of a differeniaed produc produced abroad. Here and in he following, an aserisk denoes a foreign variable. Wih idenical preferences a home and abroad and he law-of-one-price holding for each differeniaed good, i immediaely follows from Eq. (3) ha purchasing * * power pariy holds: P = S P, where denoes he aggregae foreign price level. P 2.2 The Srucure of Financial Markes In addiion o real balances, households hold inernaionally raded domesic and foreign nominal bonds. When deriving he opimal allocaion of heir wealh beween hese hree asses, households have o ake ino accoun ha inernaional bond markes are no perfecly inegraed. Whereas home households have free access o he domesic capial marke, hey incur inermediaion coss when underaking posiions in he inernaional bond marke. Similarly, foreign households can rade foreign currency denominaed bonds wihou incurring ransacion coss bu hey incur inermediaion coss when rading in domesic currency denominaed bonds. The inermediaion cos for aking posiions in he inernaional bond marke are a convex funcion of he level of funds ransferred from he domesic o he foreign bond marke in period (see Suherland, 1996). Thus, he funcional form of he real inermediaion coss, Z, incurred by domesic households when underaking posiions in he inernaional bond marke is given by Z =, (4) 2 0.5ψ I

9 7 where ψ > 0 is a posiive consan and denoes he level of real funds ransferred by domesic households from he domesic o he foreign bond marke. Boh Z and I are denominaed in erms of he consumpion aggregae, C. I The income received by domesic households consiss of he yield on heir holdings of domesic and foreign bonds, he profi income for he ownership of domesic firms (i.e., dividend income), and he labor income. Summing up hese income componens, he households deermine heir opimal consumpion and decide on heir preferred domesic and foreign bond holdings and heir preferred holding of domesic nominal balances. In addiion, hey pay axes and incur he ransacion coss for underaking posiions in he inernaional bond marke. Consequenly, he dynamics of Home households domesic bond holdings can be described by he following period-budge consrain: D = ( 1+ R 1 ) D 1 + M 1 M + w N PC P I P Z + Π P T, (5) ~ where D denoes for he quaniy of domesic currency denominaed bonds, R denoes he T nominal ineres rae on domesic bonds beween period and + 1, denoes real lumpsum axes (denominaed in erms of he consumpion aggregaor, C ), w denoes he nominal ~ wage rae earned in a perfecly compeiive domesic labor marke, and Π (z) denoes he nominal profi income he firm owned by he household earns upon selling is produc z in he goods marke. Assuming furher ha labor is he only producion facor firms use o produce produc z and ha he producion funcion is given by (z) = ( z), he nominal ~ profi income is given by Π ( z) = p ( z) y ( z) w y ( z). y N The dynamics of he domesic households foreign bond holdings are given by:

10 8 F = ( 1+ * R ) * F P I, (6) where * R denoes he nominal foreign ineres rae paid for holding a foreign bond beween period and Individual Maximizaion Maximizing expeced life-ime uiliy subjec o Eqs. (5) and (6) and assuming ha he usual ransversaliy condiion applies, one can derive he following firs-order condiions describing he household's opimal consumpion choice, money holdings, labor supply, and domesic and foreign bond holdings: (1/ C h ( σ 1) / σ 1/ σ ( h hσ σ ) / σ ( σ 1) / σ 1 ) C βhc E ( C+ 1 ) = λ P, (7) ε χ( M / P ) 1 ) = λ P, (8) + βp E ( λ+ κ y z µ 1 ( ) = λ, (9) w ( 1 + R ) β ( λ ) + 1 = λ, (10) E λ S * * β ( 1+ R ) E ( λ+ 1S+ 1) + ψλ S I = β (1 + R ) ψe ( λ+ 1S+ 1I + 1), (11)

11 9 where λ denoes he Lagrange muliplier. Similar firs-order condiions can be derived for Foreign households. Eq. (11) implies ha allowing for inermediaion coss for underaking posiions in inernaional financial markes ( ψ > 0 ) implies ha he no-arbirage condiion of uncovered ineres rae pariy includes erms accouning for he inermediaion coss incurred when ransferring funds beween he domesic and he foreign bond marke. 2.4 Price Seing Because each firm has monopoly power on he marke for he differeniaed good i produces, i reas he price i charges as a choice variable. One herefore has o specify a price-seing mechanism for (z) p. In his paper, I follow Suherland (1996) and Senay (2000) and assume ha firms se he prices of heir producs according o a discree-ime version of he price adjusmen mechanism developed by Calvo (1983). According o his price adjusmen mechanism, each firm has o ake ino accoun when seing is profi-maximizing price ha here is a posiive probabiliy 0 <γ < 1 ha i canno revise is price seing decision made in period s < in period. Firms, herefore, se he curren price of heir produc so as o maximize he expeced presen value, V (z), of curren and fuure real profis, where period s, s >, profis are weighed by he probabiliy ha he curren period price will sill be in force in period s. Firms maximize s max V ( z) = E ζ, s p ( z) s= ~ γ Π ( z) / P, (12) s s

12 10 1 where ζ Π (1 RR denoes he marke real discoun facor and RR denoes he, s j= s + j ) domesic real ineres rae. Carrying ou he maximizaion in equaion (12), he profimaximizing price can be expressed as p ( z) = θ θ E 1 E γ s= s= s γ ζ s, s ζ ( Q, s s ( Q / P )(1/ P ) s s s s θ / P )(1/ P ) s w θ s, (13) where Q nc + * * * ( 1 n) C + ng + (1 n) G + nz + (1 n) Z denoes he aggregae world demand and G denoes domesic real governmen purchases. An analogous expression can be derived for he profi-maximizing price se by foreign firms. 2.5 Fiscal Policy The domesic governmen collecs lump-sum axes and uses hem ogeher wih seignorage revenues o finance real governmen purchases, G : G = T + ( M M ) 1 / P, (14) where real governmen purchases are denominaed in erms of he consumpion aggregaor,. C To analyze he dynamic adjusmen pahs of he endogenous variables of he model in response o a fiscal policy shock, I also have o specify a sochasic process describing he

13 11 dynamics of G. As in Suherland (1996) and Senay (2000), I assume ha he fiscal policy shock evolves according o a simple auoregressive process: ˆ = ˆ. (15) G ρ GG 1 + ε G, A variable wih a ha denoes deviaions from he pre-shock seady sae. In he numerical simulaions below, I follow Suherland (1996) and Senay (2000) and assume ha he innovaion erms, ε G,, in he domesic and foreign fiscal policy process are perfecly negaively correlaed, i.e., fiscal policy shocks are asymmeric. This is clearly a somewha resricive assumpion. However, i has he advanage ha he resuls I repor in his paper are comparable o he resuls derived by Suherland. 2.6 Moneary Policy The policy conduced by he domesic and he foreign cenral bank can be described by means of a simple moneary policy rule. In he case of he domesic cenral bank, he moneary policy I assume in his paper has he following general forma: Mˆ = µ ˆ ˆ Pˆ µ, (16) 1M 1 + µ 2 y + 3 where denoes he firs-difference operaor. A similar moneary policy rule applies in he case of he foreign cenral bank. This moneary policy rule has hree main advanages. Firs, i ness he moneary policy used by Suherland (1996). Suherland assumes ha µ 1 [0,1] and µ 2 =µ 3 = 0. I would be more difficul o compare my resuls wih hose derived by

14 12 Suherland if I had decided o use, for example, a varian of he ineres-rae argeing rule suggesed by Taylor (1993) o describe cenral bank policy. Second, using his moneary policy rule guaranees ha he long-run effecs of a fiscal policy shock are comparable o hose described by Suherland (1996). The reason for his is ha he long-run seady-sae inflaion and he long-run rae of oupu growh are boh zero. As a resul, in he long-run, he moneary policy rule is idenical o he moneary policy rule used by Suherland. The fac ha he seady-sae effecs of a fiscal policy shock are comparable o hose described by Suherland allows focusing aenion on he differences beween he implicaions of Suherland s model and of my model wih respec o he effecs of a fiscal policy shock a business-cycle frequencies. Third, he moneary policy rule given in Eq. (16) has he advanage ha i is general enough so ha i can be used o discuss he implicaions of various more specific moneary policy rules. For example, if µ = 0 1 and µ 0 2 =µ 3 <, his moneary policy rule implies ha he cenral bank arges nominal income. Nominal income argeing has been recenly discussed in he conex of a NOEM model by McCallum and Nelson (1999). If µ 3 < µ 1 = µ 2 = 0, he cenral bank adops a sraegy of a sric inflaion response, regardless of he sance of he real economy. If µ < 0 and µ < 3 0, he cenral bank reacs o boh a rise 2 in inflaion and a rise in he rae of oupu growh. Because he cenral bank reacs o oupu growh (and no o variaions in he level of oupu), his ype of cenral bank policy can be compared o wha Walsh (forhcoming) calls a speed limi policy. 2.6 Definiion of Equilibrium In a symmeric monopolisic compeiion equilibrium in each counry, oupu, consumpion, he exchange rae, prices, ineres raes and wage raes, domesic and foreign bond holdings

15 13 follow processes such ha (i) he labor marke in each counry clears, (ii) he opimaliy condiions for consumpion and asse holding are saisfied, (iii) he ineremporal budge consrain for each counry is saisfied, (iv) he markes for domesic and foreign bonds are in equilibrium, and, (v) firms price seing, he dynamics of governmen spending, and cenral bank policy saisfy Eqs. (13), (15), and (16), and heir foreign counerpars, respecively. 3. Capial Mobiliy and he Effeciveness of Fiscal Policy To analyze he implicaions of varying he degree of inernaional capial mobiliy for he effeciveness of fiscal policy, I follow Obsfeld and Rogoff (1995) and Suherland (1996) and log-linearize he model laid ou in Secion 2 around a symmeric flexible-price seady sae in which he domesic and foreign asse posiions are zero. To solve he model, I use he algorihm developed by Klein (2000). The calibraion of he model is fairly sandard and follows Suherland (1996). Inser Table 1 abou here. 3.1 Impulse Response Analysis The impulse response funcions depiced in Panel A of Figure 1 visualize he impac of a permanen uni asymmeric fiscal policy shock on key domesic variables. To compue he impulse responses ploed in his figure, I assume ha µ 2 = µ 3 = h = 0. In oher words, here is no habi formaion and he moneary policy rule is as given in Suherland (1996). In his case, my model collapses o Suherland s model. Thus, he impulse responses ploed in Panel A of Figure 1 are idenical o he impulse responses o a permanen asymmeric fiscal policy shock implied by Suherland s model. These impulse responses serve as a benchmark agains which I can assess how my modificaions of he model change he macro-dynamic effecs riggered

16 14 by a fiscal policy shock. In Panel B of Figure 1, I show how a permanen asymmeric fiscal policy shock propagaes hrough he economy if he calibraion of he model is such ha h = 0 and µ =µ 0. Thus, in his scenario, he domesic and foreign cenral banks pursue 2 3 < a sraegy of nominal income argeing. Inser Figure 1 abou here. I consider firs he impulse response funcions depiced in Panel A. In he model described in his paper, an expansionary fiscal policy shock represens a negaive wealh effec for households. This negaive wealh effec induces households o decrease consumpion and o increase heir work effor. Because fiscal policy shocks are asymmeric, he macroeconomic adjusmen process aking place in he foreign economy is a mirror-image of ha aking place in he domesic economy. As a consequence, he relaive demand for domesic currency declines. The resuling nominal depreciaion resuls in an increase of he erms of rade (he home currency price of goods produced abroad relaive o he home currency price of goods produced in he domesic economy). This movemen in he erms of rade riggers an expendiure swiching effec implying ha he demand for domesic (foreign) producs increases. In his siuaion, domesic firms increase oupu. This is profiable because prices are above marginal coss. How does inernaional capial mobiliy affec he dynamics of he model? To answer his quesion, i is useful o wrie down he log-linear form of he condiion of uncovered ineres rae pariy: ( 1 β )(ˆ i ˆ *) ( ˆ ˆ ) ~ ( ˆ ˆ i = E S 1 S + E I 1 I ) (16) + ψ +

17 15 where î denoes he domesic nominal ineres rae and ψ ~ ψc0 ( C 0 denoes he level of consumpion in he pre-shock seady sae). Eq. (16) shows ha wih inernaional bond markes being imperfecly inegraed ( ψ ~ > 0 ), he dynamics of he foreign bond holdings of households (i.e., capial flows) are refleced in he condiion of uncovered ineres rae pariy. This direc effec of he change in he foreign bond holdings on he inernaional nominal yield differenial is absen in a world of high capial mobiliy ( ψ ~ = 0 ). In he case of a fiscal policy shock, he domesic economy runs a curren accoun defici, so ha is foreign asse posiion decreases. However, because he economy rapidly converges o is pos-shock seady sae, he expeced growh rae of capial inflows is negaive. This effec is large enough so ha he expeced rae of appreciaion of he domesic currency is larger wih segmened inernaional bond markes, implying ha he nominal exchange rae overshoos is pos-shock seady-sae level in he shor run. Taking accoun of he implicaions of his effec for he dynamics of he erms of rade, i follows ha he oupu effec of he fiscal policy shock is larger in he case of low capial mobiliy as compared o he case of high capial mobiliy. Panel B shows ha hings are differen if moneary policy adops a sraegy of nominal income argeing. In his case, he fiscal policy shock induces a shor-run increase in home nominal oupu growh. The home cenral bank ries o couner his increase in nominal oupu growh. As a resul, he supply of domesic money decreases. In he regime of low capial mobiliy, he rae of growh of nominal oupu in he immediae afermah of he fiscal policy shock is larger han in a regime of high capial mobiliy. Consequenly, he decrease in he home money supply is relaively sronger if capial mobiliy is low. As prices adjus, he growh of nominal income decreases and, as a resul, he home money supply sars increasing. The resuling shif in he relaive supply of home and foreign money supply implies ha he nominal exchange rae sars depreciaing.

18 16 When money supply sars increasing, he nominal ineres rae is higher in he regime of high capial mobiliy as compared o he regime of low capial mobiliy. In consequence, he rae of depreciaion of he nominal exchange rae ends o be higher if capial mobiliy is high. In fac, he rae a which he nominal exchange rae depreciaes is large enough so ha he exchange rae overshoos is long-run pos-shock seady-sae level. This, in urn, implies ha he rae of oupu growh during his ransiion phase is higher if capial mobiliy is high. As a resul, he oupu impulse response funcion applying in he regime of high capial mobiliy assumes a hump-shaped form, implying ha he maximum oupu effec of he fiscal policy shock increases in he degree of inernaional capial mobiliy. Thus, fiscal and moneary policy ineracions can have significan effecs on he relaive effeciveness of fiscal policy in a regime of low and a regime of high inernaional capial mobiliy. 3.2 Sensiiviy Analysis In his secion, I offer some furher examples ha confirm he resul derived in Secion 2. To his end, I analyze he implicaions of changes in he moneary policy rule and in he calibraion of he model for he effeciveness of fiscal policy in a regime of high and a regime of low capial mobiliy. I begin my analysis by sudying how changes in he specificaion of he moneary policy rule pursued by he cenral banks affec my main resul. Figure 2 summarizes he resuls of his analysis. The impulse response funcions depiced in he figure sugges ha he resul ha he effeciveness of fiscal policy can increase in an environmen in which inernaional bond markes become more inegraed also obains if he cenral banks pursue a speed limi policy or if an auoregressive componen is added o he moneary policy rule. In he former case, he cenral banks ry o couner increases in he growh rae of real oupu and in he inflaion rae. In he laer case, he lagged money supply is included in he moneary policy rule.

19 17 Ineresingly, he Mundell-Fleming resul ha fiscal policy is more effecive if capial mobiliy is low is resored if he home and foreign cenral banks pursue a policy of srong inflaion response, regardless of he sance of he business cycle. The reason for his is ha he price-seing mechanism I use in his paper does no add subsanial inflaion ineria o he dynamics of he model, so ha he moneary policy rule in his case comes close o he moneary policy rule used by Suherland (1996). Though he assumpion ha he cenral banks oally neglec he developmen of real oupu and are only concerned abou inflaion dynamics is somewha unrealisic, his resul shows ha he specificaion of he moneary policy is imporan for he relaive effeciveness of fiscal policy in a regime of high and a regime of low inernaional capial mobiliy. Inser Figure 2 abou here. Figure 3 gives some addiional resuls for alernaive calibraions of he model. To generae he impulse response funcions for oupu depiced in his figure, I assume ha moneary policy can be described in erms of a speed limi policy. I consider four alernaive calibraions of he model. (1) I analyze how habi formaion influences he macroeconomic effecs of a fiscal policy shock. Habi formaion may be imporan because i srenghens he consumpion smoohing incenives of households. Because consumpion smoohing becomes an especially imporan issue if capial mobiliy is high, i is ineresing o analyze how habi formaion affecs he main resul of his paper. To his end, I se he habi persisence parameer h equal o 0.8, which lies in he range of recen empirical esimaes. If h > 0, households have preferences over boh he level and he rae of change of consumpion. (2) I analyze he implicaions of a variaion in he curvaure of households period uiliy funcion wih respec o consumpion. To his end, I assume logarihmic preferences and change he parameer σ from σ = 0.75 in he benchmark model o σ = (3) I analyze he impac of a

20 18 change in he parameer θ on he simulaion resuls. In he benchmark model, his parameer assumes he numerical value 6. To assess he robusness of he main resul of my analysis, I se his parameer equal o 11. This implies ha he mark up, θ, charged by monopolisic firms in he goods marke is cu from 20 percen o 10 percen. (4) I assume ha firms depar from he Calvo-syle price-seing mechanism given in Eq. (13). The Calvo-syle price-seing mechanism implies ha marginal coss and expeced nex period inflaion are imporan for he curren rae of change of prices. Fuhrer und Moore (1995) have argued ha some ype of backward-looking elemen should be inroduced ino inflaion dynamics in order o replicae he empirically observed persisence in inflaion. In order o capure his idea, I slighly modify he price-seing mechanism implied by Eq. (13). I assume /( θ 1) = βγ ((1 ϕ) E p(z ˆ ) 1 + ϕ pˆ( z) ) + (1 βγ w, (13 ) pˆ ( z) + 1 ) where is he firs-difference operaor and ϕ [0,1] capures he exen o which firms ake pas inflaion ino accoun when deermining he curren rae of change in he prices of heir goods. If ϕ = 0, Eq. (13 ) reduces o he inflaion dynamics implied by he Calvo-syle priceseing mechanism given in Eq. (13). I assume ha ϕ = 0.2, which is in he range of empirical esimaes (see Gali e al., 2001). Inser Figure 3 abou here. The poin o ake home is ha he resuls summarized in Figure 3 indicae ha he main resul of his paper is robus wih respec o changes in he consumpion funcion, he priceseing mechanism, and he calibraion of he model. In all four variaions of he model I analyze in Figure 3, a higher degree of inernaional capial mobiliy amplifies he oupu effecs of fiscal policy a business-cycle frequencies.

21 19 4. Conclusions In his paper, I provided an example showing ha in a fairly sandard, reasonably calibraed NOEM model, higher capial mobiliy need no diminish he effeciveness of fiscal policy as measured in erms of is oupu effecs. This ends o be he case if moneary policy can be described by means of a simple moneary policy rule. The resul of my analysis underscores ha i is imporan o ake ino accoun he ineracion beween fiscal and moneary policy when analyzing he impac of he ongoing inegraion of inernaional financial markes for he way fiscal policy shocks propagae hrough he economy. I inenionally kep he model I used o reconsider he implicaions of inernaional capial mobiliy for he effeciveness of fiscal policy very simple. The simpliciy of he model assured ha is basic srucure coincides wih he srucure of he model used in a previous sudy by Suherland (1996). Of course, is simpliciy also implies ha he model could be exended in several dimensions. For example, i would be ineresing o assess in fuure work how capial mobiliy affecs he effeciveness of a deb-financed fiscal policy in he ype of model I analyzed in his paper. I would also be ineresing o sudy wheher he resuls I derived in his paper change if governmen purchases are valued in consumpion. While he resuls ha drop ou of such analyses may differ from he resuls I repored in his paper, my resuls in any case sugges ha i should no be aken for graned ha higher capial mobiliy diminishes he effeciveness of fiscal policy in open economies.

22 20 References Calvo, Guillermo A.: Saggered Prices in a Uiliy-Maximizing Framework. Journal of Moneary Economics 12 (1983): Fleming, J. Marcus: Domesic Financial Policies Under Fixed and Under Floaing Exchange Raes. I.M.F. Saff Papers 9 (1962): Fuhrer, Jeffrey C. and George R. Moore: Inflaion Persisence. Quarerly Journal of Economics 110 (1995): Fuhrer, Jeffrey C.: Habi Formaion in Consumpion and is Implicaions for Moneary- Policy Models. American Economic Review 90 (2002): Gali, Jordi, Mark Gerler, and David Lopez-Salido: European Inflaion Dynamics. European Economic Review 45 (2001): Greenwood, Jeremy and Ken P. Kimbrough: Capial Conrols and Fiscal Policy in he World Economy. Canadian Journal of Economics 18 (1985): Hallwood, C. Paul and Ronald MacDonald: Inernaional Money and Finance. Blackwell Publishers, Oxford and Malden (Mass.), Klein, Paul: Using he Generalized Schur Form o Solve a Mulivariae Linear Raional Expecaions Model. Journal of Economic Dynamics and Conrol 24 (2000): McCallum, Benne and Edward Nelson: Nominal Income Targeing in an Open-Economy Opimizing Model. Journal of Moneary Economics 43 (1999):

23 21 Mundell, Rober A.: Capial Mobiliy and Sabilizaion Policy Under Fixed and Flexible Exchange Raes. Canadian Journal of Economics and Poliical Science 29 (1963): Obsfeld, Maurice and Kenneh Rogoff: Exchange Rae Dynamics Redux. Journal of Poliical Economy 103 (1995): Senay, Özge: Moneary Policy in an Open Economy: Economic Inegraion, Disinflaion and Sabilizaion. Ph.D. hesis. Universiy of Mancheser, Chaper 3. Briish Thesis Service, Wes Yorkshire, Unied Kingdom, Suherland, Alan: Financial Marke Inegraion and Macroeconomic Volailiy. Scandinavian Journal of Economics 98 (1996): Taylor, John B.: Discreion versus Policy Rules in Pracice. Carnegie-Rocheser Conference Series on Public Policy 39 (1993): Walsh, Carl E.: Speed Limi Policies: The Oupu Gap and Opimal Moneary Policy. American Economic Review (forhcoming).

24 22 Figures and Tables Figure 1 Capial mobiliy and he dynamic effecs of a fiscal policy shock PANEL A: Supply of cenral bank money is consan PANEL B: Nominal income argeing Noe: Dashed lines apply in he regime of high capial mobiliy ( ψ ~ = 0) and solid lines apply in he regime of low capial mobiliy ( ψ ~ = 5). In he case of nominal income argeing, I se µ. Consumpion, oupu, 2 =µ 3 = 1.0 he nominal exchange rae, money supply, and he erms of rade are measured as percenage deviaions from he seady sae. Ineres raes are compued as percenage poin deviaions from he pre-shock seady sae.

25 23 Figure 2 Alernaive moneary policy rules and he oupu effec of a fiscal policy shock Noe: Dashed lines apply in he regime of high capial mobiliy ( ψ ~ = 0) and solid lines apply in he regime of low capial mobiliy ( ψ ~ = 5). Oupu is measured as percenage deviaions from he pre-shock seady sae. In he case of nominal income argeing, I se µ 1 = 0 and µ =µ 1.0. In he case of he speed limi policy, I se 2 3 = µ 1 = 0 and µ = 0.5 and µ = 1.0. When adding he auoregressive componen o he nominal income 2 3 argeing rule, I se µ. In he case of he srong inflaion response policy, I se 1 = 0.25 µ 1 =µ 2 = 0 and µ. 3 = 1.0

26 24 Figure 3 Variaion of key model parameers and he oupu effec of a fiscal policy shock under a speed limi policy Noe: Dashed lines apply in he regime of high capial mobiliy ( ψ ~ = 0) and solid lines apply in he regime of low capial mobiliy ( ψ ~ = 5). To analyze he implicaions of habi formaion, I se h = 0.8. To analyze he implicaions of logarihmic uiliy, I se σ = 1.0. To analyze he influence of he mark up parameer, I assume ha he mark up is 10 percen (θ = 10). To analyze he implicaions of inflaion ineria, I se ϕ = 0. 2 in Eq. (13 ). The parameers of he moneary policy rule are µ,, and = 0 µ 2 = 0. 5 µ 3 =

27 25 Table 1 The calibraed parameers Parameer Value Descripion β 0.95 Subjecive discoun facor σ 0.75 Ineremporal elasiciy of subsiuion θ 6.0 Inraemporal elasiciy of subsiuion ε 9.0 Inverse of he elasiciy of uiliy from real balances µ 1.4 Labor supply elasiciy ψ ~ 5 (0) Coss for underaking posiions in inernaional financial marke in he case of low (high) capial mobiliy n 0.5 Counry size Noe: For parameer values, see Suherland (1996).