ESRI Discussion Paper Series No.285
Non-Wasteful Government Spending in an Estimated Open Economy DSGE Model:
Two Fiscal Policy Puzzles Revisited

Yasuharu Iwata
Special Fellow, Economic and Social Research Institute, Cabinet Office

Abstract

This paper examines two fiscal policy puzzles related to the effects of government spending shocks. Contrary to theoretical predictions, recent empirical evidence suggests a crowding-in of consumption and a depreciation of the real exchange rate after a government spending increase. While several studies have been made to reconcile the conflicting results, this paper provides new time-series evidence and proposes an alternative explanation using the Japanese data. The empirical responses of consumption and the real exchange rate after government spending shocks are shown to be well-replicated by an estimated medium-scale open economy dynamic stochastic general equilibrium (DSGE) model augmented with (i) Edgeworth complementarity between private and public consumption, and (ii) productive public capital. Furthermore, sensitivity analysis suggests that the combination of Edgeworth complementarity, home bias, and incomplete asset market allows the model to account for an immediate increase in consumption and for a hump-shaped depreciation of the real exchange rate after a government consumption shock. This result is potentially important in preventing the model from showing the consumption-real exchange rate anomaly after the shock.


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  2. Abstract
  3. page2
    1 Introduction
  4. page6
    2 Time-Series Evidence
    1. page6
      2.1 The Structural VAR and Identification Methodology
    2. page8
      2.2 VAR Evidence on Government Spending Shocks with Sign Restrictions
  5. page9
    3 The Model
    1. page9
      3.1 Firms
      1. page10
        3.1.1 Domestic-good producing firms
      2. page13
        3.1.2 Importing firms and import-good wholesalers
      3. page15
        3.1.3 Exporting firms and export-good wholesalers
      4. page16
        3.1.4 Domestic and foreign retailers
      5. page17
        3.1.5 Relative prices
    2. page18
      3.2 Households
      1. page18
        3.2.1 Preferences and constraints
      2. page20
        3.2.2 Choice of allocations
      3. page20
        3.2.3 Wage setting
    3. page21
      3.3 Fiscal and Monetary Authoritie
      1. page21
        3.3.1 Fiscal policy
      2. page22
        3.3.2 Monetary policy
    4. page23
      3.4 Market Clearing Conditions
      1. page23
        3.4.1 The aggregate resource constraint
      2. page23
        3.4.2 Evolution of net foreign assets
    5. page24
      3.5 Foreign Economy
  6. page24
    4 Bayesian Estimation of the Model
    1. page24
      4.1 Data and Measurement Equations
    2. page25
      4.2 Preliminary Settings
    3. page26
      4.3 Estimation Results
  7. page28
    5 Non-Wasteful Government Spending in Open Economies
    1. page28
      5.1 Impulse Responses to Government Spending Shocks
      1. page29
        5.1.1 Government consumption shocks
      2. page29
        5.1.2 Government investment shocks
    2. page30
      5.2 The Transmission Mechanism
      1. page30
        5.2.1 International risk-sharing condition
      2. page31
        5.2.2 Home bias, incomplete asset markets, and the consumption-real exchange rate anomaly
  8. page33
    6 Conclusion
  9. page35
    References
  10. page42
    Table 1. Set of imposed sign restrictions
  11. page43
    Table 2.a. Prior and posterior distributions - Benchmark model (M1)
  12. page44
    Table 2.b. Prior and posterior distributions - Benchmark model (M1)
  13. page45
    Table 2.c. Prior and posterior distributions - Benchmark model (M1)
  14. page46
    Table 3.a. Posterior mean estimates under different types of parameter restrictions
  15. page47
    Table 3.b. Posterior mean estimates under different types of parameter restrictions
  16. page48
    Table 4. Log marginal data densities and posterior odds
  17. page49
    Table 5. Impact multipliers
  18. page50
    Figure 1.a. Impulse responses to an expansionary government consumption shock one standard deviation in size
  19. page51
    Figure 1.b. Impulse responses to an expansionary government consumption shock one standard deviation in size
  20. page52
    Figure 2.a. Impulse responses to an expansionary government investment shock one standard deviation in size
  21. page53
    Figure 2.b. Impulse responses to an expansionary government investment shock one standard deviation in size
  22. page54
    Figure 3.a. Model responses to a government consumption shock equal to one percent of the steady-state output
  23. page55
    Figure 3.b. Model responses to a government consumption shock equal to one percent of the steady-state output
  24. page56
    Figure 4.a. Model responses to a government investment shock equal to one percent of thesteady-state output
  25. page57
    Figure 4.b. Model responses to a government investment shock equal to one percent of thesteady-state output
  26. page58
    Figure 5. Sensitivity for home bias
  27. page58
    Figure 6. Sensitivity for incomplete asset market assumption
  28. page58
    Figure 7. Model responses to government consumption (left panel) and government investment(right panel) shocks equal to one percent of the steady-state output
  29. page59
    Appendix
  30. page59
    A Log-linearized Model
    1. page59
      A.1 Firms
      1. page59
        A.1.1 Domestic-good producing firms
      2. page59
        A.1.2 Importing firms and import-good wholesalers
      3. page60
        A.1.3 Exporting firms and export-good wholesalers
      4. page40
        A.1.4 Domestic and foreign retailers
      5. page61
        A.1.5 Relative Prices
    2. page61
      A.2 Households
      1. page61
        A.2.1 Consumption Euler Equation
      2. page62
        A.2.2 Investment Euler Equation
      3. page62
        A.2.3 Q Equation
      4. page62
        A.2.4 Capital Utilization Decision Equation
      5. page62
        A.2.5 Capital Law of Motion
      6. page62
        A.2.6 Real Wage Law of Motion
      7. page63
        A.2.7 Risk-adjusted UIP Condition
      8. page63
        A.2.8 Evolution of Net Foreign Assets
    3. page63
      A.3 Fiscal and Monetary Authorities
      1. page63
        A.3.1 Fiscal Policy Rules
      2. page64
        A.3.2 Monetary Policy Rule
    4. page64
      A.4 Aggregation and Market Clearinga
      1. page64
        A.4.1 Aggregate Production Equation
      2. page64
        A.4.2 Goods Market Equilibrium Condition
    5. page65
      A.5 Measurement Equations
  31. page66
    B Computation of the Steady State
  32. page69
    C Supplementary Figures
    1. page69
      Figure C.1. Prior-posterior plots for the benchmark model (M1)
    2. page70
      Figure C.2. Prior-posterior plots for the benchmark model (M1)
    3. page71
      Figure C.3. Prior-posterior plots for the benchmark model (M1)
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