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Monetay and fiscal policy in Euro area

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  • Monetary and Fiscal Policies in the Euro-Area

    Macro Modelling, Learning and Empirics

    Willi Semmler, Alfred Greiner and Wenlang Zhang

    Center for Empirical Macroeconomics, Bielefeld University, Germany and New School University, NewYork

    Center for Empirical Macroeconomics, Bielefeld University, Germany.Center for Empirical Macroeconomics, Bielefeld University, Germany.

  • Contents

    1 Introduction 1

    I Monetary Policy 6

    2 Empirical Evidence of the IS and Phillips Curves 82.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82.2 The IS and Phillips Curves with Backward-Looking Behavior . . . . . . . . . 92.3 The IS and Phillips Curves with Forward-Looking Behavior . . . . . . . . . . 122.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

    3 Time-Varying Phillips Curve 203.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203.2 Time-Varying Reaction to the Unemployment Gap . . . . . . . . . . . . . . 213.3 Time-Varying NAIRU with Supply Shocks . . . . . . . . . . . . . . . . . . . 243.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

    4 Time-Varying Monetary Policy Reaction Function 374.1 Monetary Policy Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374.2 Money-Supply and Interest-Rate Rules . . . . . . . . . . . . . . . . . . . . . 384.3 The OLS Regression and Chow Break-Point Tests of the Interest-Rate Rule . 424.4 Estimation of the Time-Varying Interest-Rate Rule with the Kalman Filter . 484.5 Parameter Changes in a Forward-Looking Monetary Policy Rule . . . . . . . 584.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

    5 Euro-Area Monetary Policy Effects Using US Monetary Policy Rules 635.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 635.2 Simulation Using the Time-Varying Coefficient Taylor Rule of the US . . . . 645.3 Simulation Using the Fixed Coefficient Taylor Rule of the US . . . . . . . . 665.4 Simulation Using the Suggested Taylor Rules and Actual Interest Rate . . . 685.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

    6 Optimal Monetary Policy and Adaptive Learning 756.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 756.2 Discrete-Time Deterministic Dynamic Programming . . . . . . . . . . . . . . 756.3 Deriving an Optimal Monetary Policy Rule . . . . . . . . . . . . . . . . . . . 77

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  • CONTENTS 2

    6.4 Monetary Policy Rules with Adaptive Learning . . . . . . . . . . . . . . . . 856.5 Monetary Policy Rules with Robust Control . . . . . . . . . . . . . . . . . . 906.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

    7 Time-Varying Optimal Monetary Policy 997.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 997.2 The Central Banks Control Problem . . . . . . . . . . . . . . . . . . . . . . 1017.3 Hysteresis Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1077.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1127.5 Appendix: Non-Quadratic Welfare Function and the Use of the HJB-Equation 113

    8 Asset Price Volatility and Monetary Policy 1168.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1168.2 The Basic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1188.3 Monetary Policy Rule in Practice: The Case of the Euro-Area . . . . . . . . 1228.4 Endogenizing Probabilities and a Nonlinear Monetary Policy Rule . . . . . . 1248.5 The Zero Bound on the Nominal Interest Rate . . . . . . . . . . . . . . . . . 1308.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

    II Fiscal Policy 136

    9 Fiscal Policy and Economic Growth 1389.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1389.2 The Growth Model and Steady State Results . . . . . . . . . . . . . . . . . . 1399.3 Analytical Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1429.4 Numerical Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1499.5 The Estimation of the Model . . . . . . . . . . . . . . . . . . . . . . . . . . 1529.6 Comparison of our Results with the Literature . . . . . . . . . . . . . . . . . 1589.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1599.8 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

    10 Testing Sustainability of Fiscal Policies 16310.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16310.2 Theoretical Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16410.3 Empirical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16810.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18110.5 Appendix: Proposition 2 with a time-varying interest rate and GDP growth

    rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18210.6 Appendix: Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

    11 Stabilization of Public Debt and Macroeconomic Performance 18311.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18311.2 Granger Causality Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18411.3 Sustainability Indicators of Fiscal Policy in Finite Time . . . . . . . . . . . . 18711.4 Testing a Nonlinear Relationship . . . . . . . . . . . . . . . . . . . . . . . . 191

  • CONTENTS 3

    11.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

    III Monetary and Fiscal Policy Interactions 194

    12 Monetary and Fiscal Policy Interactions in the Euro-Area 19612.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19612.2 Recent Literature on Monetary and Fiscal Policy Interactions . . . . . . . . 19612.3 Monetary and Fiscal Policy Interactions in the Euro-Area . . . . . . . . . . . 19912.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206

    13 Time-Varying Monetary and Fiscal Policy Interactions 20813.1 Monetary and Fiscal Policy Interactions in a State-Space Model with Markov-

    Switching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20813.2 Monetary and Fiscal Policy Interactions with Forward-Looking Behavior . . 21313.3 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216

    Bibliography 217

  • Chapter 1

    Introduction

    1.1 General Remarks

    This is a book on the macroeconomy and monetary and fiscal policies in the Euro-area.The Euro-area is a unified currency union since 1999, yet attempts to coordinate monetaryand fiscal policies have been pursued before the monetary unification of the Euro-area coun-tries. Before and after the introduction of the Euro in 1999 policies were characterized bythe challenges arising from the emergence of a new macroeconomythe macroeconomy ofthe Euro-area countries. In this book the study of the learning of the new macroeconomicenvironment and the learning of appropriate policy responses are based on dynamic macroe-conomic and macroeconometric models. We elaborate on many macroeconomic issues of theEuro-area, such as output stabilization, the Phillips curve, inflation rates, economic growth,employment, time-varying NAIRU, asset price bubbles, growth and fiscal policy, sustainabil-ity of public debt, the macroeconomic effects of fiscal consolidation, the empirics of monetaryand fiscal policy interaction and so on. Yet, we want to stress that the response of policies canbest be discussed in the context of dynamic macroeconomic and macroeconometric models.On the other hand, we are aware that such quantitative studies on the emergence of a newmacroeconomy and the learning of the new macroeconomic environment and appropriatepolicy responses also face great challenges.

    1.2 Monetary Policy

    Concerning monetary policy, in general it is increasingly recognized that quantitative mod-elling faces great challenges because of (1) uncertainty on what the model should look likethat monetary authorities presume private agents are following (model uncertainty), (2) un-certainty about the actual situation of the economy (data uncertainty), (3) uncertainty aboutthe size of shocks and (4) uncertainty concerning the effects of policy actions (uncertaintyabout short- and long-run real effects). It is of no surprise that in most countries neitherprivate agents reactions to monetary policy actions nor monetary policy behavior has beenstable over time. Assumed models, underlying private behavior reaction coefficients of basiceconomic relations and monetary policy behavior change over time. Moreover, what hasbeen called the NAIRU has changed over time, too. Researchers have also characterized

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  • 2monetary regimes where, over some time period, economic and monetary relationships aswell as monetary policy appear to be relatively stable, subsequently followed by strong shiftsand regime changes. This seems to be characteristic for many advanced countries, but moreso for Euro-area countries. This leads to the question whether the monetary policy in Eu-rope was too restrictive and what the appropriate policy should have been. Maybe therehave been too strong policy reactions to past inflation pressures and the new macroeconomicenvironment has not been learned properly.

    Numerous researchers have maintained t