Fiscal expansions under flexible exchange rates and in a monetary union [Elektronische Ressource] : the interplay of biased preferences and pricing-to-market / vorgelegt von Ingo Pitterle

FISCAL EXPANSIONS UNDER FLEXIBLE EXCHANGE
RATES AND IN A MONETARY UNION:
THE INTERPLAY OF BIASED PREFERENCES AND
PRICING-TO-MARKET
Inaugural-Dissertation
zur Erlangung des Doktorgrades
an der Wirtschaftswissenschaftlichen Fakult at
der Eberhard-Karls-Universit at Tubingen?
vorgelegt von
Ingo Pitterle
aus Schw abisch Gmund?
2005Dekan: Prof. Dr. J org Baten
Erstkorrektor: Prof. Dr. Uwe Walz
Zweitkorrektorin: Prof. Dr. Claudia Buch
Tag der mundlic? hen Prufung:? 4. November 2005
iiTable of Contents
Table of Contents iii
List of Figures vi
1 Introduction 1
2 Fiscal Policy in New Open Economy Macroeconomics 7
2.1 The Redux Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.2 Major Extensions of the Redux Model . . . . . . . . . . . . . . . . . 11
3 Major Building Blocks 15
3.1 The Scale Variable of Money Demand . . . . . . . . . . . . . . . . . . 16
3.2 A Home Bias in Consumption . . . . . . . . . . . . . . . . . . . . . . 18
3.3 Pricing-to-Market Behavior of Firms . . . . . . . . . . . . . . . . . . 26
4 Fiscal Policy under Flexible Exchange Rates 37
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
4.2 Model Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
4.2.1 Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
4.2.2 Central Banks and Governments. . . . . . . . . . . . . . . . . 48
4.2.3 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
4.3 Short Run and Long Run Equilibrium . . . . . . . . . . . . . . . . . 53
4.3.1 Steady State. . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
4.3.2 Long Run Equilibrium . . . . . . . . . . . . . . . . . . . . . . 57
4.3.3 Short Run . . . . . . . . . . . . . . . . . . . . . . 64
4.4 Consumption and Output Effects . . . . . . . . . . . . . . . . . . . . 77
4.4.1 World Consumption and Output . . . . . . . . . . . . . . . . 78
4.4.2 Short Run Responses . . . . . . . . . . . . . . . 80
4.4.3 Short Run Output Responses . . . . . . . . . . . . . . . . . . 84
4.4.4 Long Run Consumption Responses . . . . . . . . . . . . . . . 86
iii4.4.5 Long Run Output Responses. . . . . . . . . . . . . . . . . . . 90
4.4.6 Net Present Value Analysis . . . . . . . . . . . . . . . . . . . 92
4.5 Welfare Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.5.1 Short-Run Utility . . . . . . . . . . . . . . . . . . . . . . . . . 101
4.5.2 Long-Run Utility . . . . . . . . . . . . . . . . . . . . . . . . . 104
4.5.3 Overall Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
4.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
5 Fiscal Policy in a Monetary Union 121
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
5.2 Model Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
5.2.1 Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
5.2.2 Central Bank and Governments . . . . . . . . . . . . . . . . . 125
5.2.3 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
5.3 Short and Long Run Equilibrium . . . . . . . . . . . . . . . . . . . . 128
5.3.1 Steady state . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
5.3.2 Long run equilibrium . . . . . . . . . . . . . . . . . . . . . . . 129
5.3.3 Short Run Equilibrium . . . . . . . . . . . . . . . . . . . . . . 131
5.4 Consumption and Output Effects . . . . . . . . . . . . . . . . . . . . 136
5.4.1 World Consumption and Output . . . . . . . . . . . . . . . . 136
5.4.2 Short Run Responses . . . . . . . . . . . . . . . 137
5.4.3 Short Run Output Responses . . . . . . . . . . . . . . . . . . 139
5.4.4 Long Run Consumption and Output Responses . . . . . . . . 142
5.4.5 Net Present Value Analysis . . . . . . . . . . . . . . . . . . . 146
5.5 Welfare Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
5.5.1 Short-Run Utility . . . . . . . . . . . . . . . . . . . . . . . . . 149
5.5.2 Long-Run Utility . . . . . . . . . . . . . . . . . . . . . . . . . 150
5.5.3 Overall Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
5.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
6 Comparison of Exchange Rate Regimes 159
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
6.2 Output Effects of Fiscal Expansions . . . . . . . . . . . . . . . . . . . 161
6.3 Welfare of Fiscal . . . . . . . . . . . . . . . . . . . 166
6.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
7 Conclusion 173
7.1 Main Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
7.2 Caveats and Possible Extensions . . . . . . . . . . . . . . . . . . . . . 177
ivA Appendix to Chapter 4 181
A.1 The Linearized Long Run Equilibrium . . . . . . . . . . . . . . . . . 181
A.2 The Long Run Consumption Differential . . . . . . . . . . . . . . . . 182
A.3 The Linearized Short Run . . . . . . . . . . . . . . . . . 184
A.4 The Short Run Exchange Rate Response . . . . . . . . . . . . . . . . 185
B Appendix to Chapter 5 187
B.1 The Linearized Long Run Equilibrium . . . . . . . . . . . . . . . . . 187
C Appendix to Chapter 6 189
C.1 Production and Utility Differentials under Permanent Expansions . . 189
Bibliography 191
vviList of Figures
4.1 Short run exchange rate (permanent shock) . . . . . . . . . . . . . . 72
4.2 Short run exchange rate (temporary shock) . . . . . . . . . . . . . . . 74
4.3 Trade balance (permanent shock) . . . . . . . . . . . . . . . . . . . . 77
4.4 Trade balance (temporary shock) . . . . . . . . . . . . . . . . . . . . 78
4.5 Short run consumption (permanent shock) . . . . . . . . . . . . . . . 82
4.6 Short run (temporary shock) . . . . . . . . . . . . . . . 83
4.7 Short run production (permanent shock) . . . . . . . . . . . . . . . . 86
4.8 Short run production (temporary shock) . . . . . . . . . . . . . . . . 87
4.9 Long run consumption (permanent shock) . . . . . . . . . . . . . . . 88
4.10 Long run (temporary shock) . . . . . . . . . . . . . . . 89
4.11 Long run production (permanent shock) . . . . . . . . . . . . . . . . 91
4.12 Short run production (temporary shock) . . . . . . . . . . . . . . . . 92
4.13 Overall output (permanent shock) . . . . . . . . . . . . . . . . . . . . 93
4.14 Overall output (temporary shock) . . . . . . . . . . . . . . . . . . . . 94
4.15 Overall consumption (permanent shock) . . . . . . . . . . . . . . . . 97
4.16 Overall (temporary shock). . . . . . . . . . . . . . . . . 98
4.17 Short run utility (permanent shock) . . . . . . . . . . . . . . . . . . . 103
4.18 Short run utility (temporary shock) . . . . . . . . . . . . . . . . . . . 104
vii4.19 Long run utility (permanent shock) . . . . . . . . . . . . . . . . . . . 105
4.20 Long run utility (temporary shock) . . . . . . . . . . . . . . . . . . . 106
4.21 Overall utility (permanent shock) . . . . . . . . . . . . . . . . . . . . 109
4.22 Overall utility (temporary shock) . . . . . . . . . . . . . . . . . . . . 110
5.1 Trade balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
5.2 Short run consumption . . . . . . . . . . . . . . . . . . . . . . . . . . 139
5.3 Short run output . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
5.4 Long run consumption . . . . . . . . . . . . . . . . . . . . . . . . . . 143
5.5 Long run production . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
5.6 Overall output. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
5.7 Overall consumption in a monetary union . . . . . . . . . . . . . . . 147
5.8 Short run utility in a monetary union . . . . . . . . . . . . . . . . . . 150
5.9 Long run utility in a union . . . . . . . . . . . . . . . . . . 152
5.10 Overall utility in a monetary union . . . . . . . . . . . . . . . . . . . 154
6.1 Overall production differentials (temporary shock). . . . . . . . . . . 161
6.2 Short run production differentials (temporary shock). . . . . . . . . . 164
6.3 Long run production differentials (temporary shock). . . . . . . . . . 165
6.4 Overall utility differentials (temporary shock). . . . . . . . . . . . . . 166
6.5 Short run utility differentials (temporary shock). . . . . . . . . . . . . 169
6.6 Long run utility differentials (temporary shock). . . . . . . . . . . . . 170
C.1 Overall production differentials (permanent shock) . . . . . . . . . . . 189
C.2 Overall utility differentials (permanent shock) . . . . . . . . . . . . . 190
viiiChapter 1
Introduction
In this thesis we address the issue of fiscal policy under alternative exchange rate
regimes. Our analysis is located in the realm of New Open Economy Macroeco-
nomics (NOEM) - a new literature strand that has emerged from the so called Redux
model by Obstfeld and Rogoff (1995a). The NOEM approach has by and large re-
placedtheMundell-Fleming-Dornbusch(MFD)frameworkasthestandardworkhorse
of international economic policy analysis in the academic sphere.
Why do we focus on fiscal policy? The stabilization of economic activity over the
businesscycleisaneverrecurrentissueintheinternationalpolicydebate. Inprinciple,
governments and central banks can implement monetary or fiscal policies in order to
smooth out economic fluctuations. However, in recent times