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Investment Planning Costs and the effects of
Fiscal and Monetary Policy
Susanto Basu and Miles S. Kimball
Frontiers of Macroeconomics Conference, June 5-6, 2006, UQAM
Frontiers of Macro, June 2006 2
Motivation
• Search for a model that can explain effect of monetary, fiscal and technology shocks
• Sticky prices needed to explain monetary shocks
• “Old Keynesian” literature: With sticky prices and investment, increased G has no effect on Y
• We examine in New Keynesian model
• Confirm puzzle; suggest a solution
Frontiers of Macro, June 2006 3
Tobin (1955): The first DGE model of cycles?
• A “Solow” model• Exogenously fixed nominal wage• Result: Increase in G crowds out I one-for-one• Has no effect on Y
Frontiers of Macro, June 2006 4
Modern literature adds a lot
• Consumer optimization• Natural rate property• Rational expectations• Sticky prices instead of wages
We show: The upshot is now that Y falls if G rises
Frontiers of Macro, June 2006 5
A new puzzle
• Standard RBC/NK models predict that C should fall if G rises (a negative wealth shock)
• Contrary to evidence in Blanchard-Perotti (2002)• Gali et al. (2006) confirm the puzzle• Their solution: Add rule of thumb (RoT) consumers
• Motivated by Campbell-Mankiw (1989)
• Do we need Old Keynesian consumption function to solve a New Keynesian puzzle?
Frontiers of Macro, June 2006 6
Building blocks of the model
• Consumer with King-Plosser-Rebelo (1988) prefs• Calvo pricing• Capital accumulation• LM curve (exogenous money)• G shocks financed with lump-sum taxes
• Baseline model: No investment frictions
• Extended model: Investment (higher-order) adjustment costs, similar to CEE
Frontiers of Macro, June 2006 7
Why are “good” real shocks contractionary in the baseline model?
Cobb-Douglas production:
1Y ZK N F First-order condition:
1
(.)
Y Fr
K
where is the ex post markup
Frontiers of Macro, June 2006 8
“Expansionary” real shocks raise
• Price level a state variable• MC(Y,.) jumps down in response to “good” shocks
• e.g., technology improvement, lower labor taxes, or fiscal expansion (lowers wages)
• Thus, markup rises• Anticipate that will fall back to * as prices adjust• Firms delay investment to avoid capital losses• Collapse in investment demand lowers output
Frontiers of Macro, June 2006 9
KE-LM diagram
1
(.)
Y Fr
K
r
Y
KE’
KE
LM
Frontiers of Macro, June 2006 10
Monetary policy
• Clear from diagram that prediction depends on monetary policy rule• Our rule is that the authority holds M fixed
• Different policy rules might have different implications
• But the basic lesson is still that “good” real shocks will lower output, unless the central bank takes action
• Fiscal expansion is not an independent stimulus in the baseline model
Frontiers of Macro, June 2006 11
Baseline model results
0 100 200 300 400 500-0.5
0
0.5
1
1.5 OUTPUT
100 periods=1year0 100 200 300 400 500
1
2
3
4
5 G
100 periods=1year
FIGURE 1. BASELINE MODEL (cont'd)
Frontiers of Macro, June 2006 12
Baseline model results, cont’d
0 100 200 300 400 500-0.5
0
0.5
1
1.5 OUTPUT
100 periods=1year0 100 200 300 400 500
-0.5
0
0.5
1
1.5 HOURS
100 periods=1year
0 100 200 300 400 500-5
-4
-3
-2
-1
0 INVESTMENT
100 periods=1year0 100 200 300 400 500
-0.4
-0.3
-0.2
-0.1
0 CONSUMPTION
100 periods=1year
FIGURE 1. BASELINE MODEL
Frontiers of Macro, June 2006 13
Flex-price version has similar problems
0 100 200 300 400 500-0.5
0
0.5
1
1.5 OUTPUT
100 periods=1year0 100 200 300 400 500
-0.5
0
0.5
1
1.5 HOURS
100 periods=1year
0 100 200 300 400 500-5
-4
-3
-2
-1
0 INVESTMENT
100 periods=1year0 100 200 300 400 500
-0.5
-0.4
-0.3
-0.2
-0.1
0 CONSUMPTION
100 periods=1year
FIGURE 3. BASELINE FLEX-PRICE MODEL
Frontiers of Macro, June 2006 14
Ideas for a fix
• If collapse of investment leads to output decline,what if investment is hard to change?• Paper argues that higher-order adjustment costs are
also the key to hump-shaped IRFs from money, and necessary for the liquidity effect
• What else is necessary to get a positive consumption response to a negative wealth shock?
Frontiers of Macro, June 2006 15
Implications of KPR utility
1 1
1 1
0 1 1tv Nt t
t
CU e e
ln 1 ln
1 ln
t t t
t t
C r v N
r N
where 0.8 in U.S. dataWN
C
Frontiers of Macro, June 2006 16
Will KPR + higher-order costs fix?
• Suppose is small, as in most estimates• Use 0.20, from estimating KPR model with aggregate
U.S. data (Basu-Kimball, 2002)• Then a shock that requires higher N will tend to pull
up C as well• Suppose I is a state variable• Since Y = C + I + G, equilibrium with low might call
for higher Y, N, and C in response to increased G
ln 1 lnt t tC r N
Frontiers of Macro, June 2006 17
Sticky-investment model with low IES
0 100 200 300 400 500-0.5
0
0.5
1
1.5
2 OUTPUT
100 periods=1year0 100 200 300 400 500
1
2
3
4
5 G
100 periods=1year
FIGURE 4. STICKY-INVESTMENT MODEL WITH LOW IES (cont'd)
Frontiers of Macro, June 2006 18
Sticky-investment model with low IES, cont’d
0 100 200 300 400 500-0.5
0
0.5
1
1.5
2 OUTPUT
100 periods=1year0 100 200 300 400 500
-0.5
0
0.5
1
1.5
2 HOURS
100 periods=1year
0 100 200 300 400 500-5
-4
-3
-2
-1
0 INVESTMENT
100 periods=1year0 100 200 300 400 500
-0.5
0
0.5 CONSUMPTION
100 periods=1year
FIGURE 4. STICKY-INVESTMENT MODEL WITH LOW IES
Frontiers of Macro, June 2006 19
Need for cyclical markups (e.g., sticky prices)
0 100 200 300 400 500-0.5
0
0.5
1
1.5
2 OUTPUT
100 periods=1year0 100 200 300 400 500
-0.5
0
0.5
1
1.5
2 HOURS
100 periods=1year
0 100 200 300 400 500-5
-4
-3
-2
-1
0 INVESTMENT
100 periods=1year0 100 200 300 400 500
-0.5
-0.4
-0.3
-0.2
-0.1
0 CONSUMPTION
100 periods=1year
FIGURE 5. FLEX-PRICE STICKY-INVESTMENT MODEL WITH LOW IES
Frontiers of Macro, June 2006 20
Why KPR and not RoT?
• Campbell-Mankiw (1989) essentially run this equation with y instead of n
• Two variables are strongly positively correlated• Regressing c on r, n and y, find that y is never
significant (Basu-Kimball, 2002)• Micro evidence leaves no doubt that PIH is violated
by some people, some times• But are those violations big enough for us to assume
50% of disposable income goes to people who just spend what they get?
1t t tc r n
Frontiers of Macro, June 2006 21
Conclusion
• Need to use responses to multiple shocks to refine a single model of business cycles• Basic model can’t change with the type of shock
• Sticky prices + real shocks = unexpected results
• For policy purposes, need to understand what would happen without monetary intervention
• KPR and sticky investment (useful on other grounds) can explain fiscal shock/consumption puzzle
• Neither KPR nor RoT approach does a good job of explaining the extreme persistence of the positive C response (estimated at 20+ quarters by Gali et al.)