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Public Investment under Debt, Tax andMoney Financing

L. Burlon A. Locarno A. Notarpietro M. Pisani

Banca d’Italia

Central Bank Macro Modelling WorkshopBanque de France

Paris, 16-17 November 2017

The views expressed here are those of the authors and should not

be attributed to the Bank of Italy

Goal

I Evaluate the macroeconomic impact on the euro area of anincrease in public investment in infrastructures underalternative assumptions about funding sources (fiscal side)and monetary policy stance

Motivation

I Increase in public spending in infrastructure has been proposedas a way to address weak aggregate demand and low inflation

I IMF (2014), European Commission (2015), OECD (2016)

I Sustain aggregate demand in the short term, expand supplycapacity in the long run

I Exploit exceptionally low levels of borrowing costs (role ofmonetary policy)

I Cross-country coordination of fiscal stimuli may favor bilateralexports

I Cons: lack of fiscal space, implementation delays, inefficiencies

Contribution

I Model-based assessment: calibrated 3-region New KeynesianDSGE model: two euro-area (EA) regions (”Home” and restof EA, ”REA”) and rest of the world (”RW”)

I EA: monetary union, Home and REA share same monetarypolicy and exchange rate

I Fiscal policy is country-specific. Public sector leviesdistortionary taxes, issues debt, consumes and invests ininfrastructure

I Public capital enters production function of domestic goodswith private capital and labor

I Non-standard monetary policy measures (quantitative easing)have real effects via financial market segmentation

Preview of results

I Sizable medium-long term fiscal multipliers (> 1)

I If coupled with non-standard monetary policy (forwardguidance and quantitative easing), fiscal multipliers becomevery large (> 3 at peak), fiscal stimulus is self-financing andinflation increases

I Cross-country coordination enchances expansionary effects

I Funding matters: Debt-financed fiscal stimulus isgrowth-friendly in the short run but not in the long run,compared to tax-financed

I In all cases, efficiency in public investment implementation iscrucial for the stimulus to have sizable real effects

Related literature

I Coenen et al. (2013): impact on EA of European EconomicRecovery Plan (2008)

I Elekdag and Muir (2014): macroeconomic impact of publicinvestment in infrastructure in EA and Germany

I Blanchard et al. (2015): effects of fiscal expansions inEuropean core economies

I Abiad et al. (2016): empirical evidence on public investmenteffectiveness (role of efficiencty and financing)

I DeJong et al. (2017): effectiveness of public investment inthe EU

Road map

I Model setup: most relevant features, calibration

I Simulated scenarios and results

I Conclusions

Model structure: standard building blocks

I World economy: two euro-area (EA) regions (”Home” andrest of EA, ”REA”) and rest of the world (”RW”)

I Each region: final consumption and investment goods,intermediate tradable (T) and nontradable (NT) goods

I T and NT sectors use private capital, labor and public capital

I Nominal price and wage rigidities: forward-looking Phillipscurve

I Monetary policy: standard and non-standard measures(forward guidance, quantitative easing)

I Financial market segmentation allows non-standard monetarypolicy to have real effects

Model setup: fiscal policy

I Fiscal policy is country-specific. Public sector:

I Lump-sum transfers, public consumption, public investment ininfrastructure

I Distortionary taxes on labor income, capital income,consumption

I Public debt stabilized via a fiscal rule that adjusts lump-sumtransfers to achieve desired debt target

I Government budget constraint:

BSG ,t −BS

G ,t−1Rt−1+PL,tBLG ,t −

∞

∑s=1

κs−1BLG ,t−s ≤ PN,tCG ,t +PIG ,t IG ,t +TRt −Tt ,

Model setup: fiscal policyI Public debt is stabilized via lump-sum transfers:

TRt

TRt−1=

(bsG ,t

b̄sG

)−φ1

,

I Public capital accumulation

KG ,t−1 = (1− δG )KG ,t−2 + AIG ,t−1−N ,

where AIG ,t−1−N , with N ≥ 1, is authorized governmentinvestment in period t − 1−N (time-to-build lags).

I Government investment actually implemented at time t is

IG ,t =N−1∑n=0

bnAIG ,t−n

N−1∑n=0

bn = 1

Model setup: public capital in production

I Home intermediate tradable sector: production function ofgeneric firm i :

YT ,t (i) = KPT ,t (i)

α1T LUT ,t (i)α2T LRT ,t (i)

α3T (KG ,t−1)1−α1T−α2T−α3T

I Similar production function holds in the intermediatenontradable sector

I Public capital taken as given by firms

Model setup: financial segmentation

I Following Chen et al. (2012): imperfect substitutabilityamong financial assets, to relax Wallace neutrality

I In each EA region, two types of households:

I Restricted households only invest in domestic long-termsovereign bonds and own share of domestic capital producersdetails

I Unrestricted households have access to multiple financialassets and invest in physical capital (through capitalproducers, alongwith the unrestricted)

I Long-term sovereign bonds are perpetuities payingexponentially decaying coupon (see Woodford 2001) details

I Non-standard monetary policy: purchases by central bank ↓long-term interest rates =⇒ restricted households ↑consumption and investment

Model setup: capital producers

I Capital producers accumulate physical capital by demandingfinal investment goods subject to quadratic adjustment costson investment change

I Rent out capital to the domestic firms

I Maximize profits with respect to capital and investmenttaking prices as given

I Evaluate returns according to a weighted average of restrictedand unrestricted households’ stochastic discount factors(weights are the corresponding population shares)

I Net revenues are rebated (lump-sum) to domestic restrictedand unrestricted households according to their correspondingshares

Model setup: monetary policy

I Standard (Taylor-rule based) monetary policy

(Rt

R̄

)4

=

(Rt−1R̄

)4ρR(

ΠEA,t,t−3Π̄4

)(1−ρR )ρπ(

GDPEA,t

GDPEA,t−1

)(1−ρR )ρGDP

.

I Non-standard monetary policy measures: forward guidance(FG) on policy rate and purchases of EA long-term sovereignbonds

I Home long-term sovereign bonds:∫ nλR

0BLR,t (j

′)dj ′+∫ n

nλR

BLU,t (j)dj + BL

PSPP,t = BLG ,t ,

I A similar condition holds for the REA region

Long-term sovereign bonds market clearing

Unrestricted

Restricted Government

Foreign Households

PSPP

sovereign long-term

Calibration

I Parameters set in line with literature and to match EA greatratios. Home region is a relatively small country (20% of EAGDP)

I Set restricted households’ discount factor to obtain along-short term spread of 1.8pp on sovereign bonds

I Share of restricted households: 0.25 (in Home and REA).Lack of micro-evidence

I Short-term public debt (ratio to GDP): 13% in Home, 8% inREA. Long-term: 120% in Home, 93% in REA. Averageduration: 8 years

I Central bank purchases are proportional to GDP share of eachregion in EA (PSPP follows capital keys of Eurosystemmembers)

Simulated scenarios

1. Home increase in public investment (debt financed).Monetary policy:

I Taylor ruleI 2-year forward guidance (FG)

2. EA-wide increase in public investment. Monetary policy:I Taylor ruleI 2-year forward guidance (FG)I FG + Quantitative easing

3. Alternative forms of financing (EA-wide increase in pub. inv.):

I Distortionary tax-financed increaseI Monetary accommodation

4. Sensitivity analysis: efficiency in public investment increase(no direct supply-side effect, time-to-build)

Home increase in public investment

I Home government increases public investment by 1% of GDPfor 5 years, then gradually back to baseline level

I During fiscal stimulus, fiscal rule not active: after 5th yearlump-sum transfers stabilize public debt

Home increase Home increase+FG1st year LR 1st year LR

HomeGDP 0.7 1.5 0.7 1.5Inflation -0.1 0.0 0.0 0.0Short-term interest rate 0.0 0.0 0.0 0.0Long-term interest rate 0.1 0.1 0.1 0.1Public deficit 1.0 -0.4 1.0 -0.4Public debt -1.5 3.8 -1.6 3.6

REAGDP 0.0 0.0 0.1 0.0

Home public investment and FG: Home variables

10 20 30 400

1

2GDP

FG

No FG

10 20 30 40-0.2

0

0.2Annualized inflation

FG

No FG

10 20 30 40-2

0

2Consumption

FG

No FG

10 20 30 40-2

0

2Private investment

FG

No FG

10 20 30 40-5

0

5Exports

FG

No FG

10 20 30 400

1

2Imports

FG

No FG

10 20 30 400

0.5

1Labor

FG

No FG

10 20 30 400

1

2Real wage

FG

No FG

10 20 30 400

0.01

0.02Policy rate

FG

No FG

10 20 30 40-0.1

0

0.1Euro nominal exchange rate (increase=appr.)

FG

No FG

10 20 30 40-2

0

2Public deficit

FG

No FG

10 20 30 400

0.1

0.2Long-term interest rate

FG

No FG

10 20 30 40-5

0

5Total (ST+LT) public debt

FG

No FG

10 20 30 40-5

0

5Private holdings of long-term debt

FG

No FG

EA increase in public investment

I Increase in public investment (1% of GDP) simultaneouslyimplemented in Home and REA

I Same assumptions as above

EA increase EA increase+FG1st year LR 1st year LR

HomeGDP 0.9 1.7 1.9 1.8Inflation 0.2 0.0 1.1 0.0Short-term interest rate 0.1 -0.1 0.0 -0.1Long-term interest rate 0.1 0.0 0.0 -0.1Public deficit 0.9 -0.5 0.3 -0.3Public debt -2.2 2.4 -3.4 -0.9

Table: EA public investment increase and FG.

EA increase EA increase+FG1st year LR 1st year LR

REAGDP 0.9 1.5 1.8 1.6Inflation 0.2 -0.1 1.3 -0.1Long-term interest rate 0.1 -0.0 0.0 -0.1Public deficit 0.9 -0.5 0.4 -0.3Public debt -1.5 2.8 -2.6 0.4

EA public investment and FG: Home variables

10 20 30 400

2

4GDP

FG

No FG

10 20 30 40-2

0

2Annualized inflation

FG

No FG

10 20 30 400

1

2Consumption

FG

No FG

10 20 30 40-5

0

5Private investment

FG

No FG

10 20 30 400

2

4Exports

FG

No FG

10 20 30 400

2

4Imports

FG

No FG

10 20 30 400

2

4Labor

FG

No FG

10 20 30 400

1

2Real wage

FG

No FG

10 20 30 40-0.5

0

0.5Policy rate

FG

No FG

10 20 30 40-5

0

5Nominal exchange rate (increase=appreciation)

FG

No FG

10 20 30 40-1

0

1Public deficit

FG

No FG

10 20 30 40-0.2

0


FG

No FG

10 20 30 40-5

0


FG

No FG

10 20 30 40-5

0


FG

No FG

EA public investment and FG: REA variables

10 20 30 400

2

4GDP

FG

No FG

10 20 30 40-2

0


FG

No FG

10 20 30 400

1

2Consumption

FG

No FG

10 20 30 40-5

0

5Private investment

FG

No FG

10 20 30 400

2

4Exports

FG

No FG

10 20 30 400

1

2Imports

FG

No FG

10 20 30 400

2

4Labor

FG

No FG

10 20 30 400

1

2Real wage

FG

No FG

10 20 30 40-0.5

0

0.5Interest rate

FG

No FG

10 20 30 40-5

0


FG

No FG

10 20 30 40-1

0

1Public deficit

FG

No FG

10 20 30 40-0.2

0


FG

No FG

10 20 30 40-5

0


FG

No FG

10 20 30 40-5

0


FG

No FG

EA public investment and quantitative easing

I Same assumptions as above, plus quantitative easing (PublicSector Purchase Programme)

I EA’s central bank purchases: euro 180 billion per period forseven quarters (January 2015 Eurosystem PSPP)

I Long-term sovereign bond purchases in Home and REAproportional to corresponding region size as a share of EA

Table: EA public investment, FG, and PSPP

EA increase+FG FG and PSPP1st year LR 1st year LR

HomeGDP 1.9 1.8 3.0 2.6Inflation 1.1 0.1 2.1 -0.1Short-term interest rate 0.0 -0.1 0.0 0.0Long-term interest rate 0.0 -0.1 -0.5 -0.3Public deficit 0.3 -0.3 -0.6 -0.1Public debt -3.4 -0.9 -1.7 -6.7

EA public investment, FG, and PSPP: Home variables

10 20 30 400

2

4GDP

w/o PSPP

with PSPP

10 20 30 40-5

0


w/o PSPP

with PSPP

10 20 30 400

2

4Consumption

w/o PSPP

with PSPP

10 20 30 400

5

10Private investment

w/o PSPP

with PSPP

10 20 30 400

2

4Exports

w/o PSPP

with PSPP

10 20 30 400

5Imports

w/o PSPP

with PSPP

10 20 30 400

5

10Labor

w/o PSPP

with PSPP

10 20 30 40-5

0

5Real wage

w/o PSPP

with PSPP

10 20 30 40-0.5

0

0.5Policy rate

w/o PSPP

with PSPP

10 20 30 40-5

0


w/o PSPP

with PSPP

10 20 30 40-1

0

1Public deficit

w/o PSPP

with PSPP

10 20 30 40-0.5

0


w/o PSPP

with PSPP

10 20 30 40-10

0


w/o PSPP

with PSPP

10 20 30 40-20

-10


w/o PSPP

with PSPP

EA public investment, FG, and PSPP: REA variables

10 20 30 400

2

4GDP

w/o PSPP

with PSPP

10 20 30 40-5

0


w/o PSPP

with PSPP

10 20 30 400

2

4Consumption

w/o PSPP

with PSPP

10 20 30 400

5

10Private investment

w/o PSPP

with PSPP

10 20 30 40-5

0

5Exports

w/o PSPP

with PSPP

10 20 30 400

2

4Imports

w/o PSPP

with PSPP

10 20 30 400

5

10Labor

w/o PSPP

with PSPP

10 20 30 400

1

2Real wage

w/o PSPP

with PSPP

10 20 30 40-0.5

0

0.5Interest rate

w/o PSPP

with PSPP

10 20 30 40-5

0


w/o PSPP

with PSPP

10 20 30 40-1

0

1Public deficit

w/o PSPP

with PSPP

10 20 30 40-0.5

0


w/o PSPP

with PSPP

10 20 30 40-10

0


w/o PSPP

with PSPP

10 20 30 40-20

0


w/o PSPP

with PSPP

EA public investment: distortionary taxes and money

I EA increase in public investment + FG

I Increase in public investment financed by ↑ distortionary taxrates on labor, capital, and consumption

I Increase in taxes lasts for 5 years, then lump-sum transfers areused

I Alternatively: central bank buys and permanently rolls over anamount of sovereign bonds equal to increase in EA publicinvestment

I Additional supply of base money - used by fiscal authorities tobuy additional goods - contributes to keep interest rates low

Table: EA public investment financing: distortionary taxes and money

EA increase+FG Tax increase Money financing1st year LR 1st year LR 1st year LR

HomeGDP 1.9 1.8 1.6 1.9 2.3 2.1Inflation 1.1 -0.0 0.9 -0.1 1.5 0.0Short-term int. 0.0 -0.1 0.0 -0.1 0.0 -0.1Long-term int. 0.0 -0.1 -0.1 -0.1 -0.2 -0.2Public deficit 0.3 -0.3 -0.6 0.0 0.0 -0.3Public debt -3.4 -0.9 -2.6 -3.7 -2.8 -3.6

Sensitivity analysis

I Efficiency in implementing public investment decisions is key

I Lack of efficiency associated with

I no accumulation of public capital (no direct impact of publicinvestment on supply-side)

I or: slow accumulation of public investment (time-to-build,more gradual impact on supply side )

Table: EA public investment and PSPP: no-public capital accumulationand time-to-build

FG and PSPP No acc. of public K Time-to-build1st year LR 1st year LR 1st year LR

HomeGDP 3.0 2.6 1.9 0.5 1.5 2.2Inflation 2.1 -0.1 1.3 0.0 1.5 -0.2Public deficit -0.6 -0.1 -0.1 0.0 -0.9 0.1Public debt -1.7 -6.7 -0.3 -1.5 -0.3 -3.7

Conclusions

I Benefits of fiscal policy cooperation, synergies between fiscaland monetary policy

I Fiscal multiplier can be > 1 and close to 2: large GDP gains,but not enough to reduce debt-to-GDP ratio

I Larger GDP gains with simultaneous fiscal stimulus in wholeEA and monetary policy accommodation

I Monetary policy role is crucial: FG + QE =⇒ fiscalmultiplier > 3 at peak and investment spending isself-financing

I Financing method is relevant: tax-financed stimulus is lesseffective; debt financing more growth-friendly in the short runbut not in the long run

I Effectiveness of fiscal stimulus enhanced if implementationoccurs efficiently and without delays

Model setup: fiscal policy

I The short-term bond is a one-period nominal bond issued inthe domestic bond market that pays the (gross) monetarypolicy interest rate Rt .

I The gross yield to maturity at time t on the long-term bond is

RLt =

1

PLt

+ κ.

Back

Model setup: restricted households

I Restricted households have access only to the market oflong-term sovereign bonds. The budget constraint is

PLt B

LR,t

(j ′)−

∞

∑s=1

κs−1BLR,t−s

(j ′)

(1)

= Πproft

(j ′)+WR,t

(1− τ`

t

) (j ′)LR,t

(j ′)

−Pt (1 + τct )CR,t

(j ′)− ACW

R,t

(j ′)

,

where BLR,t is the amount of long-term sovereign bonds, Πprof

t

is profit from ownership of the Home capital producers. Thelong-term sovereign bonds have price PL,t and are formalizedas perpetuities paying an exponentially decaying couponκ ∈ (0, 1], following Woodford (2001) Back