Investment Planning Costs and the effects of Fiscal and Monetary Policy Susanto Basu and Miles S....

Investment Planning Costs and the effects of

Fiscal and Monetary Policy

Susanto Basu and Miles S. Kimball

Frontiers of Macroeconomics Conference, June 5-6, 2006, UQAM

Frontiers of Macro, June 2006 2

Motivation

• Search for a model that can explain effect of monetary, fiscal and technology shocks

• Sticky prices needed to explain monetary shocks

• “Old Keynesian” literature: With sticky prices and investment, increased G has no effect on Y

• We examine in New Keynesian model

• Confirm puzzle; suggest a solution


Tobin (1955): The first DGE model of cycles?

• A “Solow” model• Exogenously fixed nominal wage• Result: Increase in G crowds out I one-for-one• Has no effect on Y


Modern literature adds a lot

• Consumer optimization• Natural rate property• Rational expectations• Sticky prices instead of wages

We show: The upshot is now that Y falls if G rises


A new puzzle

• Standard RBC/NK models predict that C should fall if G rises (a negative wealth shock)

• Contrary to evidence in Blanchard-Perotti (2002)• Gali et al. (2006) confirm the puzzle• Their solution: Add rule of thumb (RoT) consumers

• Motivated by Campbell-Mankiw (1989)

• Do we need Old Keynesian consumption function to solve a New Keynesian puzzle?


Building blocks of the model

• Consumer with King-Plosser-Rebelo (1988) prefs• Calvo pricing• Capital accumulation• LM curve (exogenous money)• G shocks financed with lump-sum taxes

• Baseline model: No investment frictions

• Extended model: Investment (higher-order) adjustment costs, similar to CEE


Why are “good” real shocks contractionary in the baseline model?

Cobb-Douglas production:

1Y ZK N F First-order condition:

1

(.)

Y Fr

K

where is the ex post markup


“Expansionary” real shocks raise

• Price level a state variable• MC(Y,.) jumps down in response to “good” shocks

• e.g., technology improvement, lower labor taxes, or fiscal expansion (lowers wages)

• Thus, markup rises• Anticipate that will fall back to * as prices adjust• Firms delay investment to avoid capital losses• Collapse in investment demand lowers output


KE-LM diagram

1

(.)

Y Fr

K

r

Y

KE’

KE

LM


Monetary policy

• Clear from diagram that prediction depends on monetary policy rule• Our rule is that the authority holds M fixed

• Different policy rules might have different implications

• But the basic lesson is still that “good” real shocks will lower output, unless the central bank takes action

• Fiscal expansion is not an independent stimulus in the baseline model


Baseline model results

0 100 200 300 400 500-0.5

0

0.5

1

1.5 OUTPUT

100 periods=1year0 100 200 300 400 500

1

2

3

4

5 G

100 periods=1year

FIGURE 1. BASELINE MODEL (cont'd)


Baseline model results, cont’d

0 100 200 300 400 500-0.5

0

0.5

1

1.5 OUTPUT

100 periods=1year0 100 200 300 400 500

-0.5

0

0.5

1

1.5 HOURS

100 periods=1year

0 100 200 300 400 500-5

-4

-3

-2

-1

0 INVESTMENT

100 periods=1year0 100 200 300 400 500

-0.4

-0.3

-0.2

-0.1

0 CONSUMPTION

100 periods=1year

FIGURE 1. BASELINE MODEL


Flex-price version has similar problems

0 100 200 300 400 500-0.5

0

0.5

1

1.5 OUTPUT

100 periods=1year0 100 200 300 400 500

-0.5

0

0.5

1

1.5 HOURS

100 periods=1year

0 100 200 300 400 500-5

-4

-3

-2

-1

0 INVESTMENT

100 periods=1year0 100 200 300 400 500

-0.5

-0.4

-0.3

-0.2

-0.1

0 CONSUMPTION

100 periods=1year

FIGURE 3. BASELINE FLEX-PRICE MODEL


Ideas for a fix

• If collapse of investment leads to output decline,what if investment is hard to change?• Paper argues that higher-order adjustment costs are

also the key to hump-shaped IRFs from money, and necessary for the liquidity effect

• What else is necessary to get a positive consumption response to a negative wealth shock?


Implications of KPR utility

1 1

1 1

0 1 1tv Nt t

t

CU e e

ln 1 ln

1 ln

t t t

t t

C r v N

r N

where 0.8 in U.S. dataWN

C


Will KPR + higher-order costs fix?

• Suppose is small, as in most estimates• Use 0.20, from estimating KPR model with aggregate

U.S. data (Basu-Kimball, 2002)• Then a shock that requires higher N will tend to pull

up C as well• Suppose I is a state variable• Since Y = C + I + G, equilibrium with low might call

for higher Y, N, and C in response to increased G

ln 1 lnt t tC r N


Sticky-investment model with low IES

0 100 200 300 400 500-0.5

0

0.5

1

1.5

2 OUTPUT

100 periods=1year0 100 200 300 400 500

1

2

3

4

5 G

100 periods=1year

FIGURE 4. STICKY-INVESTMENT MODEL WITH LOW IES (cont'd)


Sticky-investment model with low IES, cont’d

0 100 200 300 400 500-0.5

0

0.5

1

1.5

2 OUTPUT

100 periods=1year0 100 200 300 400 500

-0.5

0

0.5

1

1.5

2 HOURS

100 periods=1year

0 100 200 300 400 500-5

-4

-3

-2

-1

0 INVESTMENT

100 periods=1year0 100 200 300 400 500

-0.5

0

0.5 CONSUMPTION

100 periods=1year

FIGURE 4. STICKY-INVESTMENT MODEL WITH LOW IES


Need for cyclical markups (e.g., sticky prices)

0 100 200 300 400 500-0.5

0

0.5

1

1.5

2 OUTPUT

100 periods=1year0 100 200 300 400 500

-0.5

0

0.5

1

1.5

2 HOURS

100 periods=1year

0 100 200 300 400 500-5

-4

-3

-2

-1

0 INVESTMENT

100 periods=1year0 100 200 300 400 500

-0.5

-0.4

-0.3

-0.2

-0.1

0 CONSUMPTION

100 periods=1year

FIGURE 5. FLEX-PRICE STICKY-INVESTMENT MODEL WITH LOW IES


Why KPR and not RoT?

• Campbell-Mankiw (1989) essentially run this equation with y instead of n

• Two variables are strongly positively correlated• Regressing c on r, n and y, find that y is never

significant (Basu-Kimball, 2002)• Micro evidence leaves no doubt that PIH is violated

by some people, some times• But are those violations big enough for us to assume

50% of disposable income goes to people who just spend what they get?

1t t tc r n


Conclusion

• Need to use responses to multiple shocks to refine a single model of business cycles• Basic model can’t change with the type of shock

• Sticky prices + real shocks = unexpected results

• For policy purposes, need to understand what would happen without monetary intervention

• KPR and sticky investment (useful on other grounds) can explain fiscal shock/consumption puzzle

• Neither KPR nor RoT approach does a good job of explaining the extreme persistence of the positive C response (estimated at 20+ quarters by Gali et al.)

Investment Planning Costs and the effects of Fiscal and Monetary Policy Susanto Basu and Miles S....

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