Optimal Fiscal Consolidation under Frictional Financial Markets Dejanir Silva UIUC ADEMU 2020 0 / 20
Stabilization versus Consolidation After sharp rise in spreads, European countries faced a key trade-off Sovereign spreads Unemployment Debt- to- GDP ratio 10 30 140 120 Portugal 8 Ireland Italy 100 Spain 20 6 80 % % % 60 4 10 40 2 20 0 0 0 2004 2007 2010 2013 2016 2004 2007 2010 2013 2016 2004 2007 2010 2013 2016 year year year 1 / 20
Stabilization versus Consolidation Use fiscal policy to achieve macroeconomic stabilization Sovereign spreads Unemployment Debt- to- GDP ratio 10 30 140 120 8 100 20 6 80 % % % 60 4 10 40 2 20 0 0 0 2004 2007 2010 2013 2016 2004 2007 2010 2013 2016 2004 2007 2010 2013 2016 year 1 / 20
Stabilization versus Consolidation Or engage in fiscal consolidation and reduce debt Sovereign spreads Unemployment Debt- to- GDP ratio 10 30 140 120 8 100 20 6 80 % % % 60 4 10 40 2 20 0 0 0 2004 2007 2010 2013 2016 2004 2007 2010 2013 2016 2004 2007 2010 2013 2016 year 1 / 20
Optimal Fiscal Consolidation in a Currency Union This paper: study optimal resolution of this trade-off • Optimal fiscal policy in a currency union with frictional financial markets • Rich choice of instruments: spending vs. tax choices 2 / 20
Optimal Fiscal Consolidation in a Currency Union This paper: study optimal resolution of this trade-off • Optimal fiscal policy in a currency union with frictional financial markets • Rich choice of instruments: spending vs. tax choices Two key ingredients: 1 Sticky prices ⇒ macroeconomic-stabilization motive • Open economy NK model as in Gali and Monacelli (2005) 2 Endogenous spreads ⇒ debt-management motive • Frictional financial markets as in Gabaix and Maggiori (2015) 2 / 20
Optimal Fiscal Consolidation in a Currency Union This paper: study optimal resolution of this trade-off • Optimal fiscal policy in a currency union with frictional financial markets • Rich choice of instruments: spending vs. tax choices Two key ingredients: 1 Sticky prices ⇒ macroeconomic-stabilization motive • Open economy NK model as in Gali and Monacelli (2005) 2 Endogenous spreads ⇒ debt-management motive • Frictional financial markets as in Gabaix and Maggiori (2015) Main results: • It is not optimal to engage in stimulus spending • VAT should be increasing over time • It is optimal to raise and front-load taxes: a fiscal consolidation 2 / 20
Outline Currency union with imperfect financial markets 1 Capital Flow Reversals and Boom/Bust Cycle 2 The Optimal Policy Problem 3 Optimal VAT Dynamics 4 Optimal Fiscal Consolidation 5 2 / 20
Preferences Preferences: � � � ∞ 1 − σ + χ log G t − N 1+ φ C 1 − σ e − ρ t t t dt 1 + φ 0 3 / 20
Preferences Preferences: � � � ∞ 1 − σ + χ log G t − N 1+ φ C 1 − σ e − ρ t t t dt 1 + φ 0 Consumption: aggregate of domestic and foreign goods � C H , t � 1 − α � C F , t � α C t = 1 − α α where H ∈ [0 , 1]. 3 / 20
Preferences Preferences: � � � ∞ 1 − σ + χ log G t − N 1+ φ C 1 − σ e − ρ t t t dt 1 + φ 0 Consumption: aggregate of domestic and foreign goods � C H , t � 1 − α � C F , t � α C t = 1 − α α where H ∈ [0 , 1]. Composite of country i ∈ [0 , 1]: Composite of foreign goods: �� 1 �� 1 γ ǫ � � γ − 1 γ − 1 ǫ − 1 ǫ − 1 ǫ dj C i , t = C i , t ( j ) C F , t = C di γ i , t 0 0 where ǫ > γ . 3 / 20
Preferences Preferences: � � � ∞ 1 − σ + χ log G t − N 1+ φ C 1 − σ e − ρ t t t dt 1 + φ 0 Consumption: aggregate of domestic and foreign goods � C H , t � 1 − α � C F , t � α C t = 1 − α α where H ∈ [0 , 1]. Composite of country i ∈ [0 , 1]: Composite of foreign goods: �� 1 �� 1 γ ǫ � � γ − 1 γ − 1 ǫ − 1 ǫ − 1 ǫ dj C i , t = C i , t ( j ) C F , t = C di γ i , t 0 0 where ǫ > γ . 3 / 20
Technology, profits, and pricing Technology: Y t ( j ) = A t N t ( j ) . 4 / 20
Technology, profits, and pricing Technology: Y t ( j ) = A t N t ( j ) . Profits: t ) P ∗ , c H , t − (1 + τ p Π t = (1 − τ v t ) P c H , t ( C H , t + G t ) + (1 − τ x H , t C ∗ t ) W t N t . 4 / 20
Technology, profits, and pricing Technology: Y t ( j ) = A t N t ( j ) . Profits: t ) P ∗ , c H , t − (1 + τ p Π t = (1 − τ v t ) P c H , t ( C H , t + G t ) + (1 − τ x H , t C ∗ t ) W t N t . 4 / 20
Technology, profits, and pricing Technology: Y t ( j ) = A t N t ( j ) . Profits: t ) P ∗ , c H , t − (1 + τ p Π t = (1 − τ v t ) P c H , t ( C H , t + G t ) + (1 − τ x H , t C ∗ t ) W t N t . 4 / 20
Technology, profits, and pricing Technology: Y t ( j ) = A t N t ( j ) . Profits: t ) P ∗ , c H , t − (1 + τ p Π t = (1 − τ v t ) P c H , t ( C H , t + G t ) + (1 − τ x H , t C ∗ t ) W t N t . 4 / 20
Technology, profits, and pricing Technology: Y t ( j ) = A t N t ( j ) . Profits: t ) P ∗ , c H , t − (1 + τ p Π t = (1 − τ v t ) P c H , t ( C H , t + G t ) + (1 − τ x H , t C ∗ t ) W t N t . Sticky producer prices • Producer prices P H , t ( j ) are subject to Calvo pricing • Full pass through: consumer prices are given by H , s ( j ) = P H , t ( j ) H , s ( j ) = P H , t ( j ) P ∗ , c P c , . 1 − τ v 1 − τ x s s 4 / 20
Technology, profits, and pricing Technology: Y t ( j ) = A t N t ( j ) . Profits: t ) P ∗ , c H , t − (1 + τ p Π t = (1 − τ v t ) P c H , t ( C H , t + G t ) + (1 − τ x H , t C ∗ t ) W t N t . Sticky producer prices • Producer prices P H , t ( j ) are subject to Calvo pricing • Full pass through: consumer prices are given by H , s ( j ) = P H , t ( j ) H , s ( j ) = P H , t ( j ) P ∗ , c P c , . 1 − τ v 1 − τ x s s Terms of trade: S t = P ∗ t ) P ∗ ˜ t S t = (1 − τ x t , . P H , t P H , t 4 / 20
International financial intermediaries Important: households cannot invest in foreign bonds • Arbitrage is done by international financial intermediaries • Friction as in Gabaix and Maggiori (2015): diversion of fraction Γ B I t 5 / 20
International financial intermediaries Important: households cannot invest in foreign bonds • Arbitrage is done by international financial intermediaries • Friction as in Gabaix and Maggiori (2015): diversion of fraction Γ B I t Intermediaries’ problem: V I t ) B I V I t ≥ Γ( B I t ) 2 t = max ( i t − i ∗ s . t . t B I t 5 / 20
International financial intermediaries Important: households cannot invest in foreign bonds • Arbitrage is done by international financial intermediaries • Friction as in Gabaix and Maggiori (2015): diversion of fraction Γ B I t Intermediaries’ problem: V I t ) B I V I t ≥ Γ( B I t ) 2 t = max ( i t − i ∗ s . t . t B I t Demand for domestic bonds: t = 1 B I Γ( i t − i ∗ t ) 5 / 20
International financial intermediaries Important: households cannot invest in foreign bonds • Arbitrage is done by international financial intermediaries • Friction as in Gabaix and Maggiori (2015): diversion of fraction Γ B I t Intermediaries’ problem: V I t ) B I V I t ≥ Γ( B I t ) 2 t = max ( i t − i ∗ s . t . t B I t Demand for domestic bonds: t = 1 B I Γ( i t − i ∗ t ) Country is also subject to exogenous capital flows B N t : t − ρ − Γ B N i ∗ i t = ρ + + Γ E t t ���� � �� � endogenous component exogenous component ≡ ψ t using B I t + B N t = E t , where E t is net external debt. 5 / 20
Outline Currency union with imperfect financial markets 1 Capital Flow Reversals and Boom/Bust Cycle 2 The Optimal Policy Problem 3 Optimal VAT Dynamics 4 Optimal Fiscal Consolidation 5 5 / 20
Capital inflows compressed interest rates... 10 year yield Gross Capital Inflows Net External Debt 35 100 5.5 30 Portugal Italy 5.0 25 80 Greece % (Trend GDP) Spain Germany 20 % GDP 4.5 % 60 15 4.0 10 40 5 3.5 0 2000 2002 2004 2006 2008 2000 2002 2004 2006 2008 2000 2002 2004 2006 2008 2010 Output, terms of trade, and net exports. 6 / 20
...inducing a boom financed by external debt Output Terms of trade 0.000 0.04 0.025 0.03 0.02 0.050 0.01 0.075 0.00 0.01 0.100 0 1 2 3 4 5 6 0 1 2 3 4 5 6 time time Net exports External debt Sticky prices 0.25 0.02 Flex prices 0.20 0.04 0.15 0.10 0.06 0.05 0.08 0.00 0 1 2 3 4 5 6 0 1 2 3 4 5 6 time time 7 / 20
Capital outflows generate a rise in spreads and a bust Output Terms of trade 0.01 0.075 0.00 0.01 0.050 0.02 0.025 0.03 0.000 0.04 0.05 0 1 2 3 4 5 6 0 1 2 3 4 5 6 time time Net exports External debt 0.07 Sticky prices 0.25 Flex prices 0.06 0.20 0.05 0.04 0.15 0.03 0.10 0.02 0 1 2 3 4 5 6 0 1 2 3 4 5 6 time time 8 / 20
Outline Currency union with imperfect financial markets 1 Capital Flow Reversals and Boom/Bust Cycle 2 The Optimal Policy Problem 3 Optimal VAT Dynamics 4 Optimal Fiscal Consolidation 5 8 / 20
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