Research program
Monetary and Fiscal Stabilization policies, the exchange rate and the term structure of interest rates
University Co-ordinator
Università degli Studi di MILANO-BICOCCA -
ECONOMIA POLITICA - MILANO(MI)
Research Unit Leader
Piergiovanna NATALE
Description
Our research unit is concerned with the analysis of fiscal and monetary policy interactions in the US and the Euro area. We shall estimate a New Keynesian model and use the estimated structural paramenters to investigate the design of optimal monetary and fiscal stabilization policies. The research project is based on three cornerstones: i) modelling strategy; ii) econometric methodology; iii) policy analysis. i) Modelling strategy. Conventional New Keynesian DSGE models (as discussed for instance in Galí, 2003) typically provide a very limited role for fiscal policy. The standard forward-looking IS curve is based on the assumption of "Ricardian" forward-looking consumers, who have full access to complete financial markets. This assumption is contradicted by the empirical evidence on the permanent income hypothesis which supports the view that a significant proportion of consumers are non-Ricardian. Moreover, conventional DSGE models cannot rationalize the positive response of consumption to public expenditure shocks. To account for these effects, we shall adopt the innovation proposed by Galí et al. (2002), who assume that a fraction of households are constrained to consume out of current income. By doing so, we are also able to model the demand effect of other fiscal variables, i.e. taxes and transfers. On the supply side of the economy, to our knowledge existing empirical New Keynesian DSGE models neglect fiscal distortions. We shall make a first attempt at estimating the empirical effect of the tax wedge on the Phillips curve in N-K DSGE models. We shall also explore alternative specifications. For instance, introducing some form of liquidity constraint or Blanchard-Yaari consumers would also introduce a role for wealth, and hence another channel of monetary-fiscal interaction, through the budget identity. This will allow us to analyze the specific role of public debt. Similarly, introducing persistence in external habits in consumers preferences might change the impact over time of taxation on aggregate demand and the relative effectiveness of taxation and government spending. ii) Econometric methodology. To start with, we shall follow a number of authors who estimate N-K DSGE models (Galì, Gertler and Lopez-Salido, 2003; Leith and Malley, 2002; Kara and Nelson, 2002) applying Generalized Method of Moments or Instrumental Variables techniques. One problem is that the estimated equations are highly nonlinear in parameters, and the rank condition for identification is not met unless some parameters in these two equations are fixed. In a sense, the GMM approach consists of fixing some parameters based on theoretical motivations, or earlier empirical studies, and estimating some parameters freely. In this context, it might be better to recognize at the outset that the researcher is bringing some prior information to bear on the estimation exercise by making such priors explicit. This suggests that a Bayesian approach might be a more natural vehicle to estimate New Keynesian structural models, and this is the approach followed in Smets and Wouters (2002). Moreover, the estimation of structural parameters via a Maximum Likelihood approach would likely get around the well-known difficulties associated with GMM estimation of forward-looking models (Ireland, 2003). References to the application of time-varying empirical strategies include the seminal paper by Doan, Litterman and Sims (1984), the relevant contributions based on the use of Markov Chain Monte Carlo methods (see inter alia Hamilton, 1994, and Kim and Nelson, 1999) and the modelling of stochastic volatility in the measurement equation by Cogley and Sargent (2002). iii) Policy analysis. Whilst a great deal of attention has been given in recent years to the problem of designing optimal monetary policy rules in the context of forward-looking models (see Giannoni and Woodford, 2002 for a comprehensive survey), very little attention has been paid to the issue of monetary-fiscal policy interactions over the cycle. Does a countercyclical fiscal policy assist the monetary policymaker or does the lack of co-ordination between the two policies, especially when both are highly inertial, cause a reduction in welfare? We shall use our estimated models to consider how the introduction of endogenous fiscal rules might impact on monetary policy. We shall conduct two types of experiment. First we compute some monetary policy rules, and consider how these are affected by the presence of endogenous fiscal rules. Second, we shall consider how our optimal monetary rules differ from the rules that emerge from an optimization exercise and again verify what impact assuming endogenous fiscal policy has on the divergence between the estimated and optimal monetary policy rule. We compute the optimal rule using the standard optimal control approach. The design of optimal policy rules based on structural parameters of the model is a difficult task requiring specific expertise. At this regard, researchers of the unit will collaborate with the Bologna Unit where M. Marzo has developed specific skills in this field. Our analysis will also focus on the impact that alternative versions of the fiscal-monetary mix impact on debt accumulation over the cycle. This issue is particularly important for the Euro area, where the Stability and Growth Pact can no longer ensure fiscal discipline. We shall simulate the model to assess the performance of the fiscal rules implicit in the several existing reform proposal for the SGP. The research unit has a strong research expertise in the analysis of EMU macroeconomic institutions and policies. stemming from a two year research program cofinanced by MIUR in 2000(see the website http://dipeco.economia.unimib.it/workemu/). The output of that programme has been received very well by experts in the field and it is one of the pillars on which we build the present one.
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