To react or not? Technology shocks, fiscal policy and welfare in the EU-3

Abstract

This paper develops a DSGE model to examine the quantitative macroeconomic implications of counter-cyclical fiscal policy for France, Germany and the UK. The model incorporates real wage rigidity and consumption habits, as the particular market failures justifying policy intervention. We subject the model to productivity shocks and allow policy instruments to react to the output gap and the debt-to-output ratio. A welfare analysis reveals that the most effective instrument-target combination is to use public consumption to stabilize the output gap. Moreover, welfare gains from counter-cyclical fiscal policy are much stronger in the presence of wage rigidities compared with consumption habits. Finally, since active policy and automatic stabilizers are substitutes, it is possible that relatively undistorted economies may be in need of countercyclical fiscal action due to inadequate automatic stabilizers. Abstract This paper develops a DSGE model to examine the quantitative macroeconomic implications of counter-cyclical …scal policy for France, Germany and the UK. The model incorporates real wage rigidity and consumption habits, as the particular market failures justifying policy intervention. We subject the model to productivity shocks and allow policy instruments to react to the output gap and the debtto-output ratio. A welfare analysis reveals that the most e¤ective instrument-target combination is to use public consumption to stabilize the output gap. Moreover, welfare gains from counter-cyclical …scal policy are much stronger in the presence of wage rigidities compared with consumption habits. Finally, since active policy and automatic stabilizers are substitutes, it is possible that relatively undistorted economies may be in need of countercyclical …scal action due to inadequate automatic stabilizers.We would like to thank the editor, Juergen von Hagen, an associate editor and two anonymous referees for constructive suggestions. We also thank Konstantinos Angelopoulos, Paul

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“…16 See also e.g. Uhlig (2007), Malley et al (2009) and Kliem and Uhlig (2013) for a similar specification. Microfoundations for Eq.…”

Welfare Implications of Public Education Spending Rules

“…Despite establishing that it is possible to design simple …scal resource allocation rules which can signi…cantly improve welfare, much more research 22 Contrary to traditional ad hoc macroeconomic models, recent micro-founded general equilibrium studies imply that the potential gains from active stabilization policy may be limited (see, e.g. Beetsma (2008) for a review of this literature, Malley et al (2008), and Schmitt-Grohé and Uribe (2007)). In contrast, in this paper the government's goal is to improve resource allocation not to smooth ‡uctuations so that any stabilizing e¤ects occur as a by-product of more e¢ cient resource allocation.…”

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“…This increases real wages (due to price stickiness, the increase in nominal wages is higher than the increase in prices) and reduces the profits of the monopolistic intermediate goods firms. As the real wage increases 55 , labor increases and consumption increases because with a GHH type of utility function the marginal utility of consumption increases 56 . The higher aggregate demand increases output (GDP) leading to positive present value government consumption spending multipliers with a value of 0.44.…”

“…The assumption that current-period labor supply is positively related to the current period real wage is justified as long as the substitution effect dominates the income effect in the short run. 56 With a GHH type of utility function, consumption and labor are complements, (…”