Public infrastructures, public consumption and welfare in a new open economy macro model

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1 hps://helda.helsinki.fi Public infrasrucures, public consumpion and welfare in a new open economy macro model Ganelli, Giovanni Bank of Finland 2009 Ganelli, G & Tervala, J 2009 ' Public infrasrucures, public consumpion and welfare in a new open economy macro model ' Bank of Finland Research Discussion Papers, no. 8/2009, Bank of Finland, Helsinki. hp://hdl.handle.ne/10138/39193 Downloaded from Helda, Universiy of Helsinki insiuional reposiory. This is an elecronic reprin of he original aricle. This reprin may differ from he original in paginaion and ypographic deail. Please cie he original version.

2 Giovanni Ganelli Juha Tervala Public infrasrucures, public consumpion and welfare in a new open economy macro model Bank of Finland Research Discussion Papers

3 Suomen Pankki Bank of Finland PO Box 160 FI HELSINKI Finland hp://

4 Bank of Finland Research Discussion Papers Giovanni Ganelli Juha Tervala Public infrasrucures, public consumpion and welfare in a new open economy macro model The views expressed in his paper are hose of he auhors and do no necessarily reflec he views of he Bank of Finland. Inernaional Moneary Fund, IMF Insiue, Washingon, DC 20431, USA. gganelli@imf.org. Visiing Scholar. juha.ervala@bof.fi. Corresponding auhor. We are graeful o Mark De Broeck, Russell Kincaid and Manmohan S. Kumar for heir commens. Juha Tervala would also like o hank he Yrjö Jahnsson Foundaion for heir financial suppor. The opinions presened are hose of he auhors and should no be aribued o he Inernaional Moneary Fund, is Execuive Board, or is managemen.

5 hp:// ISBN ISSN (prin) ISBN ISSN (online) Helsinki 2009

6 Public infrasrucures, public consumpion and welfare in a new open economy macro model Bank of Finland Research Discussion Papers 8/2009 Giovanni Ganelli Juha Tervala Moneary Policy and Research Deparmen Absrac This paper focuses on he rade-off faced by governmens in deciding he allocaion of public expendiures beween produciviy-enhancing public infrasrucures and uiliy-enhancing public consumpion in a wo-counry model. The resuls show ha a permanen increase in he domesic sock of public capial financed by a reducion in public consumpion raises domesic welfare if he produciviy of public capial is high and he weigh of public consumpion in privae uiliy is low compared wih privae consumpion. The effec on foreign welfare is negaive in he shor run, bu posiive in he long run. This implies ha, if foreign auhoriies care no only abou he presen discouned value of welfare bu also abou welfare dynamics, a permanen domesic reallocaion of public spending migh resul in a viruous global echnological cycle. Keywords: public spending composiion, welfare, imperfec compeiion, nominal rigidiies JEL classificaion numbers: E62, F41, H42, H54 3

7 Julkinen infrasrukuuri, julkinen kuluus ja hyvinvoini avoalouden makromallissa Suomen Pankin keskuselualoieia 8/2009 Giovanni Ganelli Juha Tervala Rahapoliiikka- ja ukimusosaso Tiiviselmä Tässä ukimuksessa analysoidaan kahden maan mallia käyäen, mien valioiden ulisi allokoida julkise meno julkisen infrasrukuurin ja hyöyä uoavien julkisen kuluusmenojen kesken. Tukimuksessa osoieaan, eä pysyvä, julkisen kuluusmenojen vähenämisellä rahoieava lisäys julkisessa infrasrukuurissa voi lisää hyvinvoinia. Hyvinvoini lisäänyy, jos julkisen infrasrukuurin uoavuus on suuri ja julkisen kuluuksen hyöy on pieni suheessa yksiyiseen kuluukseen. Koimaan julkisen menojen rakeneen muuoksen vaikuus ulkomaan hyvinvoiniin on negaiivinen lyhyellä ajalla, mua posiiivinen pikällä ajalla. Tämä merkisee, eä jos ulkomaa ei väliä ainoasaan hyvinvoinnin diskonausa nykyarvosa, vaan myös hyvinvoinnin sopeuumisesa, pysyvä muuos koimaan julkisen menojen rakeneessa voi aiheuaa posiiivisen eknologisen kiereen. Avainsana: julkisen menojen rakenne, hyvinvoini, epääydellinen kilpailu, nimellisjäykkyyde JEL-luokielu: E62, F41, H42, H54 4

8 Conens Absrac... 3 Tiiviselmä (absrac in Finnish) Inroducion The model Households The governmen Privae firms The iniial seady sae Parameerizaion A permanen shif in governmen spending composiion The impac on he domesic economy The open economy impac Welfare impac A emporary shif in governmen spending composiion Conclusions References

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10 1 Inroducion Governmens face several rade-offs in he process of planning and execuing fiscal policy. For example, a decision on he appropriae fiscal sance needs o ake in o accoun boh he shor-run impac on he economy and he long-run susainabiliy of public finances. Furhermore, decisions on he mehods of financing he defici (or on he use of he surplus) and on he composiion of public expendiures also need o be made. Wih regard o he laer issue, governmens are involved in he provision of public infrasrucures which can increase he produciviy of privae firms. 1 Examples include roads, bridges, airpors, and all hose public works, which, hough hey may be in he highes degree advanageous o a grea sociey, are, however, of such a naure ha he profi could never repay he expense o any individual or small number of individuals, and which i herefore canno be expeced ha any individual or small number of individuals should erec or mainain. (Adam Smih 1776). A he same ime, governmens spend large par of heir budges on goods and services ha can also be privaely provided and, while hey do no direcly impac he produciviy of he privae secor, are likely o affec consumers uiliy in a way similar o privae consumpion. Examples of such uiliy-enhancing spending for public consumpion include (bu are obviously no limied o) insurance programs, defense, clean srees, and public parks. This rade-off beween produciviy-enhancing public invesmen and uiliyenhancing public consumpion is ofen a he forefron of he public debae and policy discussions. Despie being a major policy issue, his rade-off has however received less aenion han i deserves in he academic lieraure. Several auhors, paricularly since he work of Aschauer (1989) have invesigaed, boh heoreically and empirically, he consequences of producive public spending. This lieraure includes Baxer and King (1993), Gramlich (1994), Glomm and Ravikumar (1997), Rioja (1999, 2003), Felensein and Morris (1990), Kalaizidakis and Kalyviis (2004), Coo-Marinez (2006), Duggal, Salzman and Klein (2007) and Linnemann and Schaber (2006). Very few papers in his lieraure, however, explicily focus on he rade-off beween producive infrasrucure spending and he welfare effecs of public consumpion. Prominen excepions are Barro (1990), who incorporaes ax-financed governmen services ha affec producion and uiliy ino an endogenous growh model, and Turnovsky and Fisher (1995), who carry ou a similar analysis using a neoclassical ineremporal framework. 1 Throughou he paper, we will use inerchangeably he expressions infrasrucure expendiure and capial expendiure. Public infrasrucures and public capial will also be used as synonymous. 7

11 In his paper we analyze he rade-off relaed o governmen spending composiion in he conex of a New Keynesian wo-counry model wih imperfec compeiion and nominal rigidiies. Our model belongs o he so-called New Open Economy Macroeconomics (NOEM) framework, which many currenly regard as he workhorse model for he analysis of macroeconomic issues in open economies. 2 Compared o he exising lieraure, one key innovaion of our paper is ha of analyzing producive public infrasrucure spending in his new modeling paradigm. While some of he papers ha we reviewed conain ingrediens of he New Keynesian open economy paradigm, we are no aware of any paper ha analyses he implicaions of public capial in a model ha feaures a he same ime imperfec compeiion, nominal rigidiies and a wo-counry world. As we already sressed above, he only papers of which we are aware ha explicily focus on he rade-off beween producive governmen spending and uiliy from public consumpion (Barro 1990; Turnovsky and Fisher 1995) do no belong o he New Keynesian srand of lieraure and do no consider marke imperfecions such as monopolisic compeiion and price rigidiies. The analysis of how he rade-off is affeced by such imperfecions is a novel conribuion of our paper. In paricular, in Secion 4 we compare our welfare resuls o hose of he previous lieraure. We find ha, conrary o Turnovsky and Fisher (1995), since iniial oupu and consumpion are sub-opimally low in our model (due o monopolisic compeiion) a shif oward producive governmen spending is welfare improving even in he shor run for plausible parameer values. In addiion, he open economy dimension is also imporan in differeniaing our welfare resuls from hose derived by Turnovsky and Fisher (1995). In our open economy framework, unlike in Turnovsky and Fisher (1995), domesic residens can also increase shor-run consumpion, and herefore welfare, by running a curren accoun defici. The above discussion implies ha our welfare resuls are more in line wih he endogenous growh model presened by Barro (1990) in which an increase in he share of producive capial in oal governmen spending is welfare-enhancing a all horizons han wih he neoclassical framework used by Turnovsky and Fisher (1995). The open-economy dimension also allows us unlike Barro (1990) and Turnovsky and Fisher (1995) o sudy he impac of a shif in domesic governmen spending composiion on he curren accoun, he exchange rae, and 2 The NOEM lieraure originaed wih he seminal paper of Obsfeld and Rogoff (1995, 1996). Subsequen imporan conribuions include, bu are no limied o, Bes and Devereux (2000, 2001), Corsei and Peseni (2001), Devereux and Engel (2002), Obsfeld and Rogoff (2000, 2002), Hau (2000), Tille (2001), Benigno and Benigno (2003), Bergin (2003), Kollman (2002), Suherland (1996, 2005), Pierdzioch (2004), and Ghironi (2006). Surveys of his lieraure are provided by Lane (2001), Sarno (2001), and Corsei (2007). Couinho (2005) focuses on he fiscal NOEM lieraure. 8

12 on foreign variables. This analysis of how public infrasrucures in one counry affec anoher counry is imporan from boh he heoreical and empirical poin of view. Clarida and Findlay (1994), for example, in a heoreical sudy of European inegraion, sress how counries engage in sraegic behavior by aking ino accoun, in heir decision on public infrasrucure invesmen, he level of public capial in neighboring counries. Empirically, imporan spillover effecs are found o be generaed by public highway spending beween USA saes (Pereira and Andraz, 2004) and by oal public capial spending beween he USA and Canada (Owyong and Thangavelu, 2001). More in general, we see our paper as furhering he heoreical analysis of fiscal policy. This is imporan because while policy makers in several counries are showing a renewed ineres in he fiscal insrumen and an increasing number of academic and policy sudies are focusing on fiscal issues, he analysis of he macroeconomic and welfare impac of fiscal policy sill receives limied aenion compared wih ha of moneary policy. In addiion, as sressed by Alesina and Peroi (1995), he academic debae on fiscal policy ends o neglec composiion issues. Fiscal policy is herefore usually modeled wih reference o a general aggregae, ofen idenified exclusively in erms of governmen consumpion of goods and services. 3 This implies ha addiional work aking ino accoun he complexiy of fiscal policy and he muli-dimensionaliy of governmens fiscal aciviies can be paricularly useful. The spiri of his paper is ha of conribuing o foser he debae in his area. Our analysis shows ha a permanen increase in domesic public infrasrucure financed by a reducion in public consumpion is welfare enhancing for domesic residens, provided ha he produciviy of public capial is no oo low and he weigh of public consumpion (compared o privae consumpion) in privae uiliy no oo high. However, since a negaive ne welfare impac canno be ruled ou, one policy implicaion is ha governmens should ake ino accoun household preferences wih respec o public provision of goods and services in deciding he composiion of public spending. The implemenaion of such a policy, moreover, has imporan inernaional implicaions. In paricular, he impac on foreign uiliy is negaive in he shor run, because foreign residens have o mee an increased global demand wihin a relaively underdeveloped (compared o domesic) public infrasrucure sysem, while hey only reap he benefis of he increased global demand in he long run. Foreign long-run welfare gains, however, more han offse he shor-erm losses. One implicaion of his analysis is ha, if foreign auhoriies care no only abou he presen discouned value of foreign uiliy, bu also abou welfare dynamics, he domesic policy change can generae incenives for reallocaion of public 3 Noeworhy excepions, besides he papers already menioned above, are Roche (1996), Finn (1998), Lane and Peroi (2003), and van der Ploeg (2006). 9

13 spending abroad. In his case, as he foreign counry ries o avoid shor-run welfare losses, i has an incenive o also increase he level of is producive public capial. A domesic policy shif can herefore resul in a viruous global echnological cycle. If he domesic shif in public spending composiion is emporary, overall domesic welfare is reduced for low levels of he produciviy of public capial, bu is increased for high levels. This implies ha governmens which value he welfare of heir ciizens should carefully evaluae he impac of planned infrasrucure projecs on he produciviy of he privae secor before changing he public spending mix, especially in cases in which he projeced increase in producive capial sock is likely o be emporary (due, for example, o uncerainy abou securing he necessary fiscal resources o mainain i in he medium and long run). The res of he paper is organized as follows. Secion 2 inroduces he model. Secion 3 discusses he parameerizaion. Secions 4 and 5 presen and discuss he resuls for he case of a permanen and of a emporary shif in public spending composiion, respecively. Secion 6 concludes. 2 The model The model is a sandard NOEM model, similar o hose developed by Obsfeld and Rogoff (1995) and Bes and Devereux (2000). Our main modelling innovaions, which are crucial for he issues we wan o invesigae, are he inroducion of producive public capial and of uiliy-enhancing public consumpion. We also assume ha nominal rigidiies ake he form of saggered price seing as in Calvo (1983), raher han one-period fixed prices. 4 The model conains wo counries. Firms and households are indexed by z [0,1]. A fracion n of households and firms are locaed in he domesic counry, while 1 n are locaed in he foreign counry. In he descripion of he model ha follows, unless equaions for he foreign counry are explicily discussed hey can be assumed o be symmeric o he equaions for he domesic counry. 4 We resric our aenion o he case of Producer Currency Pricing (PCP), in order o focus on he inernaional impac of governmen spending composiion, raher han on deviaions from he Purchasing Power Pariy. 10

14 2.1 Households Domesic households gain uiliy from privae and public consumpion and real balances. They also experience disuiliy from supplying labor. The domesic uiliy funcion is herefore given by 2 s s 1 ε s C U = β logcs + ( ) + φloggs (2.1) s= 1 ε Ps 2 χ M l (z) where 0 < β < 1 is he discoun facor, C is a composie good represening privae consumpion and P s is he price index associaed wih i. G represens public consumpion. M s denoes nominal money balances and l s (z) he household s supply of labor; ε > 0 is he inverse of he consumpion elasiciy of money demand, and χ and φ are posiive parameers. The composie privae consumpion good is defined in he following equaion as an aggregae across he individual goods produced by firms C s C θ θ 1 1 θ 1 θ = c (z) dz (2.2) 0 where θ is he elasiciy of subsiuion beween any pair of individual goods. The associaed price index is 1 n 1 1 θ 1 θ 1 θ P = p (z) dz + (Ep (z)) dz (2.3) 0 n where p (z) is he price of good z expressed in domesic currency, p (z) is he foreign currency price of foreign good z and E is he exchange rae, defined as he price of he foreign currency in erms of he domesic currency. The budge consrain of he domesic represenaive household is given by M + δd = D 1 + M 1 + w l (z) PC + π P τ (2.4) where D denoes he household s holding of domesic currency denominaed nominal bonds, which accoun for inernaional shifs in wealh, δ is he price of a bond (he inverse of one plus he nominal ineres rae), w is he nominal wage paid o he household in a compeiive labor marke, π is he household s share of profis received by firms and τ denoes real lump-sum axes paid o he 11

15 12 governmen. Given ha bonds are denominaed in domesic currency, he budge consrain of he foreign represenaive household is 1 1 P C P (z) w l M E D E D M τ + π + + = δ + (2.5) where foreign variables are denoed by aserisks. The firs order condiions are given by 1 1 C P C P β = δ + + (2.6) E C P E C P β = δ (2.7) C P w l = (2.8) C P w l = (2.9) ε δ χ = 1 1 C P M (2.10) ε + δ χ = 1 1 ) E E 1 C ( P M (2.11) Equaions (2.6) and (2.7) are he Euler equaions for opimal domesic and foreign consumpion, respecively. Equaions (2.8) and (2.9) are he domesic and foreign opimal labor supply equaions, which equae he disuiliy of supplying an exra uni of labor wih he marginal uiliy of he exra privae consumpion ha can be bough due o he marginal increase in labor supply. Finally, equaions (2.10) and (2.11) show ha households opimal money demand is an increasing funcion of privae consumpion and a decreasing funcion of he ineres rae.

16 2.2 The governmen The consolidaed budge consrain of he moneary and fiscal auhoriies, expressed in per-capia erms, is given by G M M 1 = τ + (2.12) P where oal governmen spending G is disribued beween public consumpion C I G and public capial G, according o he formula G = G + G. In he C I experimens ha we carry ou in his paper, only he composiion of (domesic) governmen spending changes. Toal governmen spending, axes and he money supply (as well as foreign composiion of governmen spending) are kep consan hroughou our exercises. Governmen consumpion akes he same form as he privae secor s consumpion index and i is hus given by G C θ θ 1 1 θ 1 C θ = g (z) dz (2.13) 0 An analogous index governs public capial spending. Governmen spending on public capial and consumpion are assumed o follow a firs-order auoregressive process described by he following equaions Ĝ I = ρĝ + σ (2.14) I 1 I Ĝ C = ρĝ + σ (2.15) C 1 C where ρ governs he persisence of a fiscal shock, σ I and σ C are unpredicable shifs in he componens of governmen spending and he ha noaion represens percenage deviaions from he iniial seady sae. 13

17 2.3 Privae firms Technology Each firm produces a differeniaed good. The producion funcion of a represenaive domesic firm z is y = ) G α (z) l (z)(k (2.16) where y (z) is he oupu of firm z, l (z) is he labor inpu used by firm z, α > 0 measures he produciviy of public capial and K G is he sock of public capial provided by governmen spending, which evolves according o K + = (1 λ)k + G (2.17) G 1 G I where λ is he depreciaion rae. One obvious shorcoming of our model is he absence of privae capial. This is a limiaion shared wih large par of he NOEM lieraure, which usually assumes ha labor is he only facor of producion. The papers discussed in he Inroducion which focus on he impac of producive public spending in a closed economy usually assume ha privae capial also eners he producion funcion. Since our framework complicaes he modeling sraegy by inroducing he open economy dimension, we absrac from privae capial so as o avoid overly complicaing he model. If public and privae capial are complemens in producion as i is likely o be he case for mos caegories of producive public invesmen (for example, roads and airpors) increasing he sock of public capial would also increase he marginal produciviy of privae capial. In his case he inroducion of privae capial in our model would produce resuls qualiaively similar o he ones we derive here. From he quaniaive poin of view, he impac of raising he share of producive public spending would be magnified. We herefore believe ha excluding privae capial does no in our model fundamenally aler he implicaions of shifing public spending owards he kind of large infrasrucure projecs ha we have in mind in moivaing his paper. Profis Domesic firms minimize heir coss w l (z) subjec o (2.16). The nominal marginal cos is given by 14

18 w MC (z) = (2.18) (K G α ) The profis of domesic firms are given by π z) = p (z)y (z) w l (z) (2.19) ( Equaions (2.19) and (2.12) can be subsiued ino he households budge consrain equaion (2.4) o derive he consolidaed budge consrain of he domesic economy δ D = D + p (z)y (z) P C P G (2.20) 1 Making use of he global asse-marke-clearing condiion nd + (1 n)d = 0, he consolidaed budge consrain of he foreign economy can be derived in an analogous way as n D n D 1 δ = + p (z)y (z) P C P G (2.21) 1 n E 1 n E The fac ha he law of one price holds in each counry and domesic and foreign households consume idenical consumpion baskes implies he following demand curve for each differeniaed good z θ p (z) W y (z) = (C + G P W ) (2.22) where W C is world privae consumpion demand, given by C W = nc + (1 n) C (2.23) and world oal governmen spending W C is defined in an analogous way. 15

19 Price seing In he absence of nominal rigidiies, each home firm would maximize is profis using p(z) as he choice variable. This would imply θ p (z) = MC (z) (2.24) θ 1 Following Calvo (1983), we inroduce nominal rigidiies by assuming ha each firm reses is prices wih a probabiliy 1 γ in each period, independenly of oher firms and independenly of he ime elapsed since he las adjusmen. Each firm has o ake ino accoun, when seing is profi-maximizing price, ha in every subsequen period here is a probabiliy 0 < γ < 1 ha i will no be able o revise is price seing decision. When seing a new price in period, each firm seeks o maximize he presen value of profis weighing fuure profis by he probabiliy ha he price will sill be effecive in ha period. Thus he represenaive home firm seeks o maximize max V (z) = p (z) s= γ s ζ,s π (z) s (2.25) where ζ,s is he domesic discoun facor beween period and period s, defined as 1 ζ,s = Π j = s(1 + i j) where i denoes he nominal ineres rae. The resul is ha he pricing rule for home good z is given by θ s W W 1 γ ζ,s(cs + Gs ) MCs(z) θ s= Ps p (z) = (2.26) θ θ 1 s W W 1 γ ζ +,s(cs Gs ) s= Ps All firms in a counry are symmeric and every firm ha changes is price in any given period chooses he same price and oupu consisenly wih (2.26). The srucure of price seing implies ha each period a fracion of 1 γ of firms ses a new price and he remaining fracion keeps heir price unchanged. 16

20 2.4 The iniial seady sae The model is log-linearized around a symmeric seady sae where all exogenous variables are consan. In addiion, iniial ne foreign asses and governmen capial spending are boh zero. In exising NOEM models oal governmen spending is usually assumed o be zero a he iniial seady sae. We depar from his pracice by assuming ha governmen consumpion is posiive and equal in boh counries a he iniial seady sae. This allows us o carry ou policy exercises in which a reducion in public consumpion is used o finance an increase in public capial. We also assume ha he iniial level of privae consumpion is equal in boh counries. Our assumpions imply ha he opimal labor supply (2.8), he pricing rule (2.24), he producion funcion (2.16) 5 and heir foreign equivalen equaions can be combined o yield he following relaionships beween seady-sae oupu, labor supply, and consumpion θ 1 y 0 = l0 = (2.27) θc0 θ 1 y = = 0 l0 (2.28) θc0 where 0 subscrips denoe he iniial seady sae. 6 3 Parameerizaion We simulae our model for a benchmark parameerizaion and we check he sensiiviy of our resuls by also considering alernaive values for he produciviy of public capial and he weigh of public consumpion in privae uiliy. In he benchmark parameerizaion, he elasiciy of subsiuion beween differeniaed goods θ is se equal o 6, implying a 20 per cen mark-up of prices over marginal coss in he seady sae. The subjecive discoun facor β is se a 1/1.05, which implies a 5 per cen annual real ineres rae. The price sickiness parameer γ is assumed o be equal o 0.5, implying an average delay beween 5 Assume ha he producion funcion in he iniial seady sae is y (z) = l (z). 6 The derivaion of equaions (2.27) (2.28) and (4.1) (4.2) is also based on he fac ha iniial oupu is equal o he sum of iniial privae and public consumpion in each counry. This is a consequence of he assumpion of zero iniial ne foreign asses holdings. 17

21 price adjusmens of wo years. 7 As i can be seen by looking a equaion (2.10) and is foreign equivalen, he parameer ε deermines boh he consumpion and ineres elasiciy of money demand. We se ε equal o 9, which implies a consumpion elasiciy of money demand of 1/9 and an ineres rae elasiciy of money demand of 1/9. 8 The wo counries are assumed o be of equal size, ie n = 0.5. The raio of iniial oal governmen spending (ie iniial public consumpion o oupu) is se o 0.2. In he benchmark simulaions presened below, we assume ha he uiliy provided by public consumpion is low compared o ha provided by privae consumpion. We herefore se φ = 0.4. We also need o specify values for he produciviy and depreciaion rae of public capial parameers, α and λ. The laer is assumed o be 0.10 (as in Baxer and King, 1993, and Rioja, 2003). The exising lieraure is far from conclusive on wha a plausible value for α could be. Glomm and Ravikumar (1997) surveys paper which have aemped o esimae he produciviy of public capial. Resuls vary from a saisically insignifican α (Hulen and Schwab, 1991) o 0.39 (Aschauer, 1989). Alhough Aschauer s upper bound is widely cied, mos sudies criicize i as oo high and find esimaes which are posiive bu much smaller. We herefore consider wo values of α in our experimens, α = 0.05 (as in Baxer and King, 1993) and α = 0.1 (as in Rioja, 2003). In wha follows we consider he domesic and inernaional impac of boh permanen and emporary shocks o governmen spending composiion in he domesic counry. In he case of permanen shocks he persisency parameer ρ is se o 1 in equaions (2.14) and (2.15). In he case of emporary shocks, we se his parameer o 0.8. We simulae he model using he algorihm developed by Klein (2000) and McCallum (2001). 4 A permanen shif in governmen spending composiion In his secion we consider a permanen one percenage increase in home governmen infrasrucure invesmen relaive o iniial oupu and a simulaneous one percenage decrease in home governmen consumpion relaive o iniial oupu. Toal governmen spending is herefore consan boh a home and in he foreign counry. The composiion of foreign public spending is unchanged compared o he iniial seady sae. We evaluae he impac of such a policy on 7 Carlon (1986) suggess ha ha in various indusries is no unusual for prices o remain unchanged for several years. 8 Our parameerizaion is mosly consisen wih Suherland (1996). 18

22 he main domesic and foreign macroeconomic variables as well as on domesic and foreign welfare. The resuls for his case are presened in Figure 4.1. The verical axes show percenage deviaions from he iniial seady sae. For variables whose iniial seady sae value is zero, he percenage deviaions are expressed in relaion o iniial oupu. 4.1 The impac on he domesic economy Figure 4.1 shows ha a shif in he composiion of public spending owards public capial generaes a boom in he domesic economy, by increasing domesic oupu. This is consisen wih he findings of oher papers which have invesigaed he impac of an increase in public capial in closed economies (for example, Baxer and King, 1993). The basic inuiion for his resul is ha an increase in public capial leads o an expansion of producion possibiliies, hus implying an increase in domesic oupu. Since he accumulaion of public capial is gradual, he increase in domesic oupu is equally gradual, wih an almos insignifican impac in he shor run. However, since domesic households anicipae he medium and long-run increase in oupu, hey increase privae consumpion immediaely in order o smooh consumpion ineremporally. This implies ha he domesic economy mus run a curren accoun defici in he shor run o be able o consume more han i is producing in anicipaion of fuure produciviy gains. Consequenly, in order o service he accumulaed exernal deb domesic oupu has o increase more han consumpion in he long run. 19

23 Figure 4.1 The effecs of a permanen shif in governmen spending composiion A prima facie inerpreaion of hese resuls could lead o he conclusion ha a domesic shif in he composiion of public spending owards public infrasrucure worsens he susainabiliy of he domesic economy by increasing is exernal deb. However, if we ake he view ha public capial increases a counry s ne worh (see, for example, Milesi-Ferrei and Moriyama, 2006), hen he accumulaion of exernal deb does no necessarily imply a worsening of oal domesic ne worh, since i is more han offse by he permanen increase in public capial. Figure 4.1 also highlighs he role of α. A higher α increases he produciviy of public capial more, hus implying a furher expansion of producion possibiliies, which resuls in higher domesic oupu. An increase in α also increases he domesic marginal produciviy of labor; his allows domesic firms o produce more oupu for a given labor inpu. Equaions (2.18) and (2.24) imply ha an increase in α would reduce prices if hese were perfecly flexible. However, due o he presence of nominal rigidiies, prices canno be reduced o fully mach he increase in produciviy. The fac ha oupu increases while prices are only parially adjused resuls in higher domesic profis in he shor run. Since domesic firms are owned by domesic households, higher profis are redisribued o hem, parly ranslaing ino higher consumpion for a higher level of α. 20

24 Figure 4.1(h) also shows ha a shif in he composiion of spending has a nonmonoonic impac on home employmen, since i ends o reduce i in he shor run, bu raise i in he medium and long run. In addiion, an increase in α has a similar non-monoonic impac. This can be seen by comparing he resuls for α = 0.05 and α = 0.1 in Figure 4.1(h). A higher α generaes lower domesic employmen in he shor-run (he firs en periods afer he shock) bu higher domesic employmen aferwards. The resuls described above reflec various effecs a work following an increase in he level and produciviy of public capial. One obvious implicaion of higher and/or more producive public capial is ha he same level of oupu can be produced wih less labor effor. This pure public capial produciviy effec explains why domesic employmen iniially falls when he level of public capial is increased, and why i falls more if he produciviy of public capial is higher. However, higher and more producive public capial also implies ha, on average, he prices of domesic goods are lower. This raises he real wage, hus generaing incenives for higher domesic labor supply. In addiion o his increase in he real wage, he domesic accumulaion of curren accoun defici reduces domesic households ne wealh, hus pushing hem o increase heir labor supply (ie o decrease heir consumpion of leisure). In he medium and long run, he wealh effec semming from he curren accoun defici, ogeher wih he impac of he higher real wage, more han offse he pure public capial produciviy effec. The ineracion of hese various effecs hus explains he non-monoonic impac of boh a shif owards public capial and of a higher α on domesic labor supply. Inuiively, hese resuls imply ha he shor-run impac of producive capial in he economy migh resul in a job-less expansion, due o he generalized increase in produciviy, while in he medium and long run he benefis of expanding he producion possibiliies of he economy will manifes hemselves no only on economic aciviy bu also on employmen. 4.2 The open economy impac As we sressed in he Inroducion, one advanage of he open economy se-up is ha i enables us o assess he impac of shifs in public spending composiion on he exchange rae and on foreign variables. Figure 4.1(e) shows ha an increase in producive capial in he domesic economy implies an appreciaion of he domesic exchange rae (a fall of he price of he foreign currency expressed in erms of he domesic currency). The main mechanism a work is a money demand effec arising hrough higher domesic consumpion: as discussed in Secion 4.1, domesic consumpion increases, boh in absolue erms and relaive o foreign one, when he domesic governmen 21

25 shifs is spending composiion owards producive capial. Since money demand is a posiive funcion of consumpion (see equaions (2.10) and (2.11)), an increase in domesic consumpion relaive o foreign one increases domesic money demand compared o foreign one. An appreciaion of he domesic currency is herefore required o reesablish equilibrium in he money marke. The fac ha domesic consumpion increases more when α is higher implies ha he money demand effec is sronger in ha case. This explains why he domesic currency appreciaes even more when public capial is more producive. Figure 4.1(c) also shows ha foreign oupu increases in he shor run and slighly declines in he long run following a shif in domesic public spending composiion, while foreign privae consumpion displays an opposie response. The shor-run increase in foreign oupu can be explained by boh an expendiure swiching and an expendiure boosing effec. The expendiure swiching effec is due o he fac ha an appreciaion of he domesic currency makes foreign goods cheaper. This shifs some of he higher world demand away from domesic and owards foreign goods. However, since he effec on he exchange rae is small in our model, so is he expendiure swiching effec. Wha accouns for he bulk of he shor-run increase in foreign oupu is herefore he expendiure boosing effec, due o higher aggregae demand in he world economy in he wake of an increase in producion possibiliies in he domesic economy. As we have seen, an immediae implicaion of he laer is a consumpion boom in he domesic economy. Since household preferences do no display home bias, par of he higher domesic demand falls on foreign goods, hus explaining why foreign oupu increases on impac. Since he sock of foreign public capial has no changed, foreign households have o mee he increased demand for heir goods wih he same pre-shock echnology, ie he foreign equivalen of equaion (2.16) wih an unchanged level of public capial. This implies ha foreign labor supply will need o increase. As he (foreign equivalen of) uiliy funcion (1) shows, he marginal disuiliy of supplying labor increases for higher levels of labor supply, while he marginal uiliy of privae consumpion is higher for lower consumpion levels. This means ha lower levels of privae consumpion (ie higher levels of marginal uiliy of consumpion) need o correspond o higher levels of labor supply (ie o higher levels of marginal disuiliy of supplying labor). In his way, foreign agens seek o compensae he higher marginal disuiliy of providing an addiional amoun of labor wih he marginal uiliy of he amoun of privae consumpion ha he increase in labor supply can buy. In he long run, however, he accumulaion of exernal asses by foreign households he oher side of he coin of he curren accoun defici run by he domesic counry implies an increase in boh privae consumpion and leisure of foreign residens. In addiion, a erms-of-rade effec is a work in he long run. A rise in supply of domesic goods worsens he domesic erms of rade (ie he 22

26 price of domesic goods relaive o foreign falls). This implies ha foreign consumpion is higher in he long run. Boh he accumulaion of exernal asses and he worsening in he domesic erms of rade have a posiive effec on longrun foreign privae consumpion. 4.3 Welfare impac In his secion we focus on he welfare impac of a shif in he domesic composiion of governmen spending. As we sressed in he Inroducion, he rade-off beween uiliy-enhancing public consumpion and produciviyenhancing public capial is ofen a crucial aspec of he public debae and of policy discussions. In spie of his, we are no aware of any paper which explicily focuses on his rade-off in he NOEM framework. The basic inuiion behind his rade-off is ha cuing spending for public consumpion direcly reduces households uiliy. However, if he cu in curren spending is used o raise public capial, his shif can also have a posiive indirec effec on households uiliy, namely hrough he impac of improved public infrasrucure on oher variables which affec privae uiliy. In our welfare analysis i is useful o look a a measure of accumulaed welfare over he long-erm planning horizon of he represenaive agen. In firs generaion NOEM models such as he seminal Redux model (Obsfeld and Rogoff, 1995) prices are fixed for one period and economies reach he seady sae in he following period. In such a framework, he welfare effec of a shock is he sum of he shor-run change in uiliy and he discouned presen value of he change in seady-sae uiliy. Since we have saggered price seing, we calculae he presen discouned value (PDV) of he change in uiliy, using a large number of periods o numerically approximae he long-erm impac. Formally, he change in domesic uiliy in period is given by du = Ĉ l lˆ + φĝ (4.1) 2 0 C while an analogous expression holds for foreign uiliy. 9 The PDV value of he change in uiliy is herefore calculaed as s du DPV = β dus (4.2) s= wih an equivalen expression holding for he foreign counry. 9 As cusomary in his lieraure, we neglec he uiliy derived from real balances. 23

27 Figure 4.1(i) illusraes he response of domesic insananeous uiliy (du ) o changes in governmen spending composiion for various combinaions of he produciviy of public capial (α) and he weigh of public consumpion in privae uiliy (φ). Figure 4.1(i) shows ha a shif in composiion oward public capial is more likely o be welfare enhancing in every period for domesic households he higher is α and he lower φ. The inuiion behind hese resuls is sraighforward. Since a decrease in public consumpion direcly lowers welfare, he direc uiliy loss of a shif in he composiion of spending is lower if households aach a low weigh o public consumpion in heir uiliy funcion. In addiion, he loss due o lower public consumpion can be compensaed by he fac ha higher public infrasrucure allow households o consume more privaely a every horizon. Furhermore, his effec is sronger for higher values of α (Figure 4.1(b)). This effec is reinforced also because higher consumpion can be achieved domesically wihou having o increase labor proporionally o he increase in consumpion. On he conrary, labor effor can even be reduced in he shor erm (Figure 4.1(h)). The welfare resuls presened in Figure 4.1(i) can be compared wih hose of previous papers. Turnovsky and Fisher (1995) look separaely a public consumpion and public invesmen expansions, raher han a a shif in composiion for a given level of oal governmen spending. They sress how in heir model a permanen expansion in public invesmen requires agens o sacrifice more welfare iniially (compared o a permanen expansion in public consumpion) in exchange for increased seady-sae welfare. 10 This implies ha, in heir model, an exercise like he one we consider would unambiguously reduce welfare on impac. This is due o he fac ha an increase in public invesmen generaes a higher level of ransiional invesmen compared o an increase in public consumpion. In Turnovsky and Fisher s neoclassical framework his can only be achieved by emporary reducing he level of privae consumpion, hus shor-run uiliy. In our model, his rade-off beween shor erm welfare losses and long-run welfare gains of a shif oward higher public invesmen can be eliminaed for reasonable parameer values (when he weigh of public consumpion in privae uiliy is no oo high). This is a resul of wo fundamenal differences beween our modeling framework and he one used by Turnovsky and Fisher (1995). Firs, due o he o he presence of imperfec compeiion, he iniial oupu and consumpion seady sae is sub-opimally low in our model. As a consequence, unlike in Turnovsky and Fisher (1995), in our framework he expansion of public capial need no happen a he expense of shor-run resources available o he privae secor. Second, he open economy dimension also implies ha, in our model, domesic households can increase shor-run consumpion, and herefore welfare, by running a curren accoun defici. This effec is absen by definiion in 10 See Turnovsky and Fisher (1995, p. 769). 24

28 Turnovsky and Fisher (1995): due o he closed-economy seing, in heir framework domesic agens are no able o increase consumpion in he shor run by accumulaing exernal deb. The discussion above implies ha, from he poin of view of he shor-run welfare effecs, our new Keynesian framework is closer o he endogenous growh model presened by Barro (1990) han o Turnovsky and Fisher (1995). In Barro (1990) an increase in he share of producive governmen spending over oal spending unambiguously raises he rae of growh of oupu and privae savings a all horizons, wih a posiive impac on uiliy. Table 4.1 PDV of change in uiliy in he case of a permanen shif in governmen spending composiion Parameerizaion du DPV du DPV α = 0.05; φ = α = 0.05; φ = α = 0.10; φ = So far, he discussion has focused on shor-run uiliy. Table 4.1 shows he PDV of welfare for he same parameerizaions considered in Figure Overall, he resuls presened in Table 4.1 sugges ha a shif oward public infrasrucure is welfare enhancing domesically if he weigh of public consumpion (compared o privae consumpion) in privae uiliy is low and/or he produciviy of public capial is high. However, since a negaive welfare impac canno be ruled ou when he weigh of public consumpion in privae uiliy is relaively high (see he case α = 0.05 and φ = 0.4) he resuls also imply ha governmens should ake ino accoun households preferences wih respec o public provision of services in order o evaluae shifs in he composiion of public spending. Similarly, given he imporance of changes in α for he welfare resuls, he impac of planned infrasrucure projecs on he produciviy of he privae secor should be evaluaed as carefully as possible before changing he public spending mix. Figure 4.1(j) presens he impac on foreign uiliy of a domesic shif in public spending composiion. The inernaional consequence of he shif in public spending decided by he home counry is a reducion of foreign insananeous uiliy in he shor run. This negaive inernaional welfare spillover is reversed in he medium and long run, due o he changes in he pahs of foreign privae consumpion and employmen discussed in secion 4.2. Table 4.1 illusraes ha he overall effec on he PDV of foreign uiliy is posiive because he posiive 11 For insance, if α = 0.05 and φ = 0.2, a permanen shif in governmen spending increases he PDV of domesic uiliy by 3.7 per cen and he PDV of foreign uiliy by 0.65 per cen. The numerical values presened in Tables 4.1 and 5.1 are calculaed using 200 periods. 25

29 medium and long run effecs of he domesic policy shif more han offse he negaive shor-run impac. The main inuiive explanaion for he increase in overall foreign welfare is relaed o he erms of rade effec: an increase in he supply of domesic goods induces an improvemen in he erms of rade of he foreign counry, resuling in a higher level of foreign consumpion. Figure 4.1(j) also shows ha he negaive shor-run impac on foreign uiliy is sronger for higher values of α. This has ineresing implicaions for inernaional policy coordinaion. In he shor run, he more efficien is he reallocaion of public spending decided by he domesic auhoriies (he higher α), he more he domesic policy change harms foreign residens. The inuiive explanaion for his resul is ha having more efficien infrasrucure generaes a compeiive advanage for he domesic economy compared o he foreign. The domesic expansion of producive possibiliies also generaes some posiive inernaional demand spillovers which parially benefi foreign residens. However, foreign residens have o mee he increased global demand wihin a relaively underdeveloped (compared o domesic) public infrasrucure sysem. Figure 4.1(j) shows ha he posiive spillover impac of he domesic policy shif does no offse he domesic compeiive advanage quickly enough o preven foreign welfare from falling in he shor run. One implicaion of his analysis is ha he domesic policy change and he associae shor run welfare loss of he foreign counry can generae incenives for reallocaion of public spending also in he foreign counry. Alhough he impac on he PDV of foreign uiliy is posiive for reasonable parameer values (Table 4.1), if foreign auhoriies are worried abou welfare dynamics (no only abou he PDV of uiliy) hey will sill ry o offse he negaive shor run effec of he domesic policy. In order o do so, hey will have an incenive o also increase he level of foreign producive public capial in response o he domesic policy. In such circumsances, a domesic policy shif can herefore rigger a viruous global echnological cycle. 26

30 5 A emporary shif in governmen spending composiion In his secion we assess he impac of a emporary shif in domesic governmen spending composiion. In his policy experimen he persisency parameer ρ is se o 0.8 in equaions (2.14) and (2.15). Figure 5.1 and Table 5.1 illusrae he resuls in his case. 12 Table 5.1 PDV of change in uiliy in he case of a emporary shif in governmen spending composiion Parameerizaion du DPV du DPV α = 0.05; φ = α = 0.10; φ = As Figure 5.1(g) shows, depreciaion of public capial implies ha he sock of public infrasrucure accumulaed while public invesmen was emporarily higher is almos compleely depleed abou 40 periods afer he shock. This dynamics implies ha he increase in produciviy of domesic firms is also only emporary. The emporary increase in produciviy brings abou a emporary rise in domesic oupu, which is, for obvious reasons, more pronounced for higher values of α (Figure 5.1(a)). Domesic households also emporarily increase consumpion following he emporary increase in produciviy (Figure 5.1(b)). For consumpion smoohing reasons analogous o hose discussed in secion 4.1, domesic households save par of he emporary higher income by running a curren accoun surplus in he medium run. Figure 5.1(f) shows ha domesic residens accumulae a permanenly higher amoun of bonds. One of he implicaions of a emporary increase in he sock of public infrasrucure is herefore a permanen improvemen in he ne worh posiion of he domesic economy. Due o higher ineres income, domesic privae consumpion is higher in he new seady sae. The shor-run response of foreign oupu and consumpion is similar o he one displayed in he case of permanen shifs in governmen spending composiion, and can be explained wih argumens analogous o he ones discussed in secion 4.2. However, since he oal expendiure boosing effec semming from an increase in domesic produciviy is smaller over he ime horizon considered, he reacion of foreign variables is also quaniaively more limied in he case of emporary shifs. 12 Figures 5.1 shows ha, alhough he soluion of he model is sable, i akes more han 40 periods o reach he new seady sae. 27

31 The accumulaion of a curren accoun defici implies ha foreign residens reduce boh heir privae consumpion and heir leisure (increase oupu) in he long run, due o reduced wealh. However, hey ineremporally smooh his behavior, hus emporarily increasing heir leisure and consumpion in he medium erm (Figure 5.1(c,d)). In addiion, he more pronounced medium-run fall in foreign oupu in he case of a higher α also reflecs some marke gains of domesic firms a he expense of foreign firms, since he nominal appreciaion of he domesic currency (Figure 5.1(e)) is more han offse by he fac ha domesic prices are likely o fall more han foreign prices in he medium run when α is higher. This in urn is because a higher level of α reduces domesic (bu no foreign) marginal coss and herefore domesic (bu no foreign) prices. Figure 5.1 The effecs of a emporary shif in governmen spending composiion Figure 5.1(i) shows ha, conrary o he case of a permanen shif, a emporary domesic policy shif can reduce domesic welfare in he shor run even when α is high (ie α = 0.1). This can inuiively be explained by he fac ha he expansion of producion possibiliies is much more limied when he shif is only emporary. Domesic households herefore canno expand privae consumpion as much as in he permanen case. The impac of he reducion of public consumpion hence C dominaes domesic uiliy in he shor run. In he long run, G reurns o he iniial level, hus neuralizing he negaive welfare impac of he emporary 28

32 reducion in public consumpion. However, domesic welfare increases in he long run (raher han jus reurning o he pre-shock level) because he higher wealh accumulaed by domesic residens hrough running a curren accoun surplus allows hem o reduce heir supply of labor while a he same ime increasing privae consumpion. Table 5.1 shows ha he PDV of domesic welfare is posiive for a high level of α (α = 0.10). In his case, he long run improvemen in uiliy more ha offses he shor run reducion in erms of PDV. On he oher hand, if α is low (α = 0.05), he PDV of domesic uiliy is negaive. In erms of foreign welfare, Figure 5.1(j) shows ha he impac on uiliy is driven by foreign consumpion and oupu movemens, and is negaive in he shor and he long run bu briefly posiive in he medium run. The shor-erm welfare loss of foreign agens is more limied compared o domesic residens, because foreigners do no see heir uiliy reduced by a cu in publicly provided consumpion. This is implies ha, as shown in Table 5.1, he PDV of foreign uiliy is posiive boh for high and for low values of α. 6 Conclusions In his paper we focused, in he conex of an open-economy model wih imperfec compeiion and nominal rigidiies, on he rade-offs faced by governmens in deciding he allocaion of public spending beween produciviy-enhancing public infrasrucures and uiliy-enhancing public consumpion. Our analysis shows ha shifs in he composiion of public spending have imporan posiive and welfare implicaions, boh domesically and abroad. In paricular, a emporary increase in he domesic sock of public capial financed by a reducion in public consumpion reduces domesic welfare if he produciviy of public capial is low. If he policy shif is permanen, domesic uiliy is increased if he produciviy of governmen spending is no oo low and he imporance of public consumpion (relaive o privae consumpion) in privae uiliy is no oo high. However, since a negaive welfare impac canno be ruled ou when he weigh of public consumpion in privae uiliy is relaively high, one policy implicaion of our resuls is ha governmens should ake ino accoun households preferences wih respec o public provision of services in order o evaluae shifs in he composiion of public spending. Similarly, given he imporance of changes in α for he welfare resuls, he impac of planned infrasrucure projecs on he produciviy of he privae secor should be evaluaed as carefully as possible before changing he public spending mix. These concerns are valid in he cases of permanen as well as emporary shifs in he composiion of public spending, since in boh cases he PDV of domesic welfare can be negaive for reasonable parameerizaions. 29

33 Wih regards o he effec on foreign welfare, a domesic shif in governmen spending implies a reducion of shor-em foreign uiliy, while he PDV of foreign welfare is posiive, as he benefis of he global expansion in demand are reaped in he medium-long run by he foreign counry. If foreign auhoriies are worried no only abou he PDV of uiliy, bu also abou welfare dynamics, hey will sill ry o offse he negaive shor-run welfare effec of he domesic policy. In his case, hey will have an incenive o increase he level of foreign producive public capial. In such a siuaion a domesic policy shif can herefore rigger a viruous global echnological cycle. Some of our resuls migh obviously be sensiive o he specificaion of our model. In paricular, we assume ha public and privae consumpion ener privae uiliy in a non-separable way. This means ha he decrease in uiliy-enhancing public consumpion necessary o finance he increase in producive public infrasrucure does no affec he marginal uiliy of privae consumpion. Nonseparabiliy beween privae and public consumpion could of course be an ineresing case o consider in fuure research. How our resuls would be affeced by he inroducion of non-separabiliy would depend on wheher public and privae consumpion are subsiue or complemens. Anoher ineresing exension of he model would be he inroducion of asymmery beween he domesic and foreign counries. This could be achieved, for example, by inroducing home bias in privae and public consumpion. 30

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