Hysteresis and full employment in a small open economy

Abstract

We simulate a small open economy Two Agent New Keynesian (TANK) model featuring 'learning by doing' in production whereby changes in employment generate hysteresis in productivity and output. Credit constraints and hysteresis amplify the efficacy of Fiscal stimulus in a small open economy with a floating exchange rate and inflationtargeting central bank such that output multipliers can exceed unity; welfare multipliers can be positive; and the degree of hysteresis, output and employment multipliers match empirical evidence well. Fiscal stimulus helps reverse output hysteresis, and price-level targeting provides superior macroeconomic stabilisation compared to other simple monetary rules combined with fiscal stimulus.

Building the Education Revolution: The Employment Effects of Fiscal Stimulus in Australia

“…The interest rate smoothing parameter in the monetary policy reaction function is on the low side, but very close to contemporaneous estimates in the Australian context, for example in Li and Spencer (2016). Support for the hysteresis process in the production technology is found in the data, with values of ρ x and µ l essentially around the midpoint of those suggested by other studies (see Chang et al, 2002;Watson and Tervala, 2021;De Long and Summers, 2012;and Reifschneider et al, 2015 for example) Following Smets and Wouters (2007), the number of replications in the MH algorithm is set to 250,000, and the burn in ratio is set to 50 per cent. The posterior mode is computed using the Covariance Matrix Adaptation Evolution Strategy (CMA-ES) algorithm proposed by Hansen and Kern (2004) 6.5 Simulated Approximate Output Multipliers…”

“…In the below, we develop a medium scale DSGE model that can motivate large 'closed economy, no monetary policy response' fiscal multipliers utilising heterogeneous households, and learning-by-doing in the production technology. The model extends the simple open economy TANK model featuring hysteresis in Watson and Tervala (2021) to include public and private investment and a more realistic fiscal structure. In this model the government levies distortionary taxes on labour, consumption and firm profits to fund government consumption, transfer payments to non-Ricardian households, and public sector investment.…”

“…For the calibrated parameters, consistent with Watson and Tervala (2021) we set β to 0.995 implying an annualised real interest rate of 2 per cent. α = 0.33 consistent with Galí (2015) and Chodorow-Reich ( 2019).…”

“…Prior means for ρ x and µ l are set equal to 0.93 and 0.2 respectively based on the estimates for Australia presented by Watson and Tervala (2021). The prior mean for the Calvo parameter γ = 0.75 is a common choice in the literature (see Galí, 2015).…”

“…The aggregate consumer Euler equation can be defined with respect to total consumption and labour supply alone following Watson and Tervala (2021):…”