BANK OF FINLAND DISCUSSION PAPERS

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1 BANK OF FINLAND DISCUSSION PAPERS Jukka Railavo Research Deparmen Effecs of he supply-side channel on sabilisaion properies of policy rules Suomen Pankin keskuselualoieia Finlands Banks diskussionsunderlag

2 Suomen Pankki Bank of Finland P.O.Box 160 FIN HELSINKI Finland hp://

3 BANK OF FINLAND DISCUSSION PAPERS Jukka Railavo* Research Deparmen Effecs of he supply-side channel on sabilisaion properies of policy rules The views expressed are hose of he auhor and do no necessarily reflec he views of he Bank of Finland. I am graeful o Juha Tarkka and Jouko Vilmunen for encouraging and helpful commens. Also he commens from Marin Ellison, Seppo Honkapohja, Jarmo Konulainen, Tuomas Takalo, Mai Virén and he paricipans of he Bank of Finland workshop on modelling of moneary policy are graefully acknowledged. I would also like o hank he paricipans of he ZEI Summer School 2003 for useful commens. * Bank of Finland, P.O. Box 160, FIN Helsinki, Finland. Tel jukka.railavo@bof.fi Suomen Pankin keskuselualoieia Finlands Banks diskussionsunderlag

4 hp:// ISBN ISSN (prin) ISBN ISSN (online) Suomen Pankin monisuskeskus Helsinki 2003

5 Effecs of he supply-side channel on sabilisaion properies of policy rules Bank of Finland Discussion Papers 34/2003 Jukka Railavo Research Deparmen Absrac In his paper we inroduce an applicaion of he supply-side channel for fiscal polico he basic New Keynesian model. We use a proporional ax rae insead of lump sum ax and inroduce he disorions of a ax wedge. We derive a closed economy forward-looking model wih governmen consumpion and no capial. Households labour supply decisions are endogenised. Moneary policy is conduced by a Taylor-ype ineres rae rule and fiscal policy follows a simple deb rule. We analyse he sabiliy of he model when fiscal policy has boh demand and supply-side effecs and compare resuls wih he sandard case of only demand effecs. We show ha aking supply-side effecs ino accoun resrics he fiscal policy parameer range consisen wih he dynamic sabiliy of he economy. We also argue ha allowing fiscal polico affec boh supply and demand resuls in more persisen inflaion as well as oupu responses o shocks, han wihou he supply-side channel. We also discuss he differen moneary and fiscal policy regimes and heir implicaion on he sabiliy of inflaion and oupu. Key words: inflaion, fiscal and moneary policy, sabilisaion JEL classificaion numbers: E52, E31, E63 3

6 Tarjonakanavan vaikuukse alouspoliiikan säänöjen vakausominaisuuksiin Suomen Pankin keskuselualoieia 34/2003 Jukka Railavo Tukimusosaso Tiiviselmä Tässä ukimuksessa arvioidaan finanssipoliiikan arjonakanavan vaikuuksia uuskeynesiläisessä mallissa. Tukimuksessa on käyey suheellisa verousa kiineän könäsummaveron sijasa, mikä uo arjonaan verokiilan aiheuamia väärisymiä. Tukimuksessa johdeaan eeenpäin kasova suljeun alouden malli, jossa ei oea huomioon pääomaa, mua joka sisälää julkisen sekorin. Koialous voi pääää ise yönarjonnasa. Rahapoliiikkaa hoideaan Taylorin säännön avulla, ja finanssipoliiikka seuraa yksinkeraisa velkasäänöä. Tukimuksessa analysoidaan mallin vakaua, kun finanssipoliiikalla on sekä kysynä- eä arjonavaikuuksia. Työssä osoieaan, eä arjonavaikuusen huomioon oaminen rajoiaa finanssipoliiikan paramerien vaiheluväliä, joka on sopusoinnussa alouden dynaamisen asapainon kanssa. Tukimuksessa väieään, eä kun finanssipoliiikan salliaan vaikuaa myös arjonaan kysynnän lisäksi, on sokkien seurauksena pysyvämpiä inflaaio- ja uoanovaikuuksia kuin ilman arjonakanavaa. Lisäksi ukimuksessa veraillaan eri raha- ja finanssipoliiikan yhdiselmiä ja niiden vaikuusa inflaaion ja uoannon vakaueen. Avainsana: inflaaio, finanssi- ja rahapoliiikka, vakaus JEL-luokielu: E52, E31, E63 4

7 Conens Absrac Inroducion The model The household The firm The governmen Policy rules Sabilising properies of he model Parameers Deb rule wih supply-side effecs Deb rule wih exogenous poenial oupu Simulaion Conclusions...25 References...26 Appendix A. The sysem wih supply-side effecs of fiscal policy...29 Appendix B. The sysem wihou supply-side effecs of fiscal policy...32 Appendix C. The model...34 Figures

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12 Wr orj0olqhdulvh hxdwlrq 5145/ zh uvw wdnh qdwxudo orjdulwkpv dqg uhduudqjh xvlqj wkh dssur{lpdwlrq *? E c 3 n E *? c n wr lhog *? c ' E *? c n *?E n r *? : +5146, Wkh hxdwlrq 5146 krogv dovr dw vwhdg vwdwh c / c n dqg r 1 Zh ghqrwh wkh vwhdg vwdwh ydoxhv ri yduldeohv zlwk edu zkloh yduldeohv zlwk kdw duh ghqhg dv orjdulwkplf iudfwlrqdo ghyldwlrqv iurp wkh vwhdg vwdwh ydoxhv1 Vxewudfw wkh vwhdg vwdwh ydoxhv iurp hxdwlrq 5146 *? c *? c ' E *? c n *? c n d*?e n r *?E n r o : +5147, Wkh orjdulwkplf ghyldwlrq iurp vwhdg vwdwh lv wkhq/ iru h{dpsoh iru frqvxpswlrq/ ec '*? c c 1 Zh dovr xvh wkh dssur{lpdwlrq *? E n er er 1 Qrz zh fdq zulwh wkh hxdwlrq 5147 lq ghyldwlrqv iurp vwhdg vwdwh irup ec ' E ec n er : +5148, Dv lq Zdovk +5336/ Fkdswhu 8,/ wkh jryhuqphqw sxufkdvhv wkh dprxqw g ri wrwdo rxwsxw lq dgglwlrq wr wkh frqvxpswlrq e krxvhkrogv1 Zh xvh wkh hfrqrp 0zlgh uhvrxufh frqvwudlqw wr holplqdwh sulydwh frqvxpswlrq ec iurp hxdwlrq Dq hfrqrp 0zlgh uhvrxufh frqvwudlqw lv ' c n g ; +5149, zkhuh vwdqgv iru wrwdo rxwsxw1 Wkh uhvrxufh frqvwudlqw lv d yhu vwulfw irupxodwlrq/ ehfdxvh wkh lqfuhdvh lq jryhuqphqw frqvxpswlrq uhsodfhv sulydwh frqvxpswlrq rqh0iru0rqh/ zklfk fdxvhv furzglqj rxw ri sulydwh frqvxpswlrq1 Orj0olqhdulvdwlrq ri wkh hxdwlrq 5149 durxqg vwhdg vwdwh lhogv 7 e ' c ec n g eg : +514:, Qh{w zh pryh hxdwlrq 514: rqh shulrg iruzdug/ wdnh h{shfwdwlrqv dqg vroyh zlwk uhvshfw wr E ec n/ dqgzhjhw E ec n ' n c n E en g n E eg n: +514;, c n Qrz zh vxevwlwxwh wkh xsgdwhg uhvrxufh frqvwudlqw hxdwlrq 514; lqwr Hxohu hxdwlrq 5148dqg zh duh deoh wr holplqdwh wkh h{shfwhg frqvxpswlrq1 Hxohu hxdwlrq lv qrz lq irup ec ' n c n E en g n E eg n c n er : +514<, Qh{w/ zh vxevwlwxwh wkh Hxohu hxdwlrq 514< edfn lqwr wkh uhvrxufh frqvwudlqw hxdwlrq 514: dqg uhduudqjh wr lhog e ' c n E en n g eg c g n E eg n +5153, c n c n g c er : 7 Iru ghwdlov/ vhh hj Xkolj +4<<<,1 43

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14 Zh vxevwlwxwh wkh hfrqrp uhvrxufh frqvwudlqw ec ' c e g c eg lqwr hxdwlrq 5159 em ' e g eg R c c e ; +515:, zklfk lv wkh orj0olqhdu prqh ghpdqg hxdwlrq1 Vlqfh prqh lv dvvxphg wr sd qr lqwhuhvw/ wkh rssruwxqlw frvw ri kroglqj prqh lv wkh qrplqdo lqwhuhvw udwh R 1 Li wkh uhdo lqwhuhvw udwh lv frqvwdqw/ wkh rssruwxqlw frvw lv dhfwhg e wkh udwh ri lq dwlrq1 Li wkh sulfh ohyho lv frqvwdqw/ lq dwlrq lv hxdo wr }hur/ wkh irujrqh hduqlqjv ri kroglqj prqh duh ghwhuplqhg e wkh uhdo lqwhuhvw udwh1 Li wkh sulfh ohyho lv ulvlqj zlwk d srvlwlyh lq dwlrq udwh/ wkh uhdo ydoxh ri prqh lv ghfolqlqj dqg wkh rssruwxqlw frvw ri kroglqj prqh lqfuhdvhv1 Lq hxloleulxp lw lv uhxluhg wkdw prqh ghpdqg hxdov prqh vxsso 1 Wr zulwh wkh prqh ghpdqg hxdwlrq 515: djdlq lq orj0ohyhov/ zh xvh wkh qrwdwlrq em '*?m *? m iru uhdo yduldeohv dqg R e '*?EnR *? nr iru qrplqdo lqwhuhvw udwh dqg jhw *? m *? m ' d*? *? y c o g d*? g *? g c o +515;, *? E n R *? nr : Zh xvh wkh vwhdg vwdwh ri wkh uhvrxufh frqvwudlqw/ wkh vwhdg vwdwh ri hxdwlrq 5158dqg dssur{lpdwlrq ri qrplqdo lqwhuhvw udwh R *? E n R wr zulwh hxdwlrq 515; lq irup *? m ' *? g *? g c c R n *? K; +515<, zklfk lv wkh prqh ghpdqg hxdwlrq zulwwhq lq +orjdulwkplf, ohyhov1 Qrz zh uhzulwh wkh krxvhkrog*v oderxu vxsso hxdwlrq 5144 e xvlqj wkh vdph shulrglfdo xwlolw ixqfwlrq dv deryh u Ec ;m ;l ' c3 n Km3 ln n Diwhu wdnlqj sduwldo ghulydwlyhv zh fdq zulwh l ' c 3 w E : +5163, Oderxu vxsso fdq eh h{suhvvhg dv l S ' c 3 w E ; +5164, zkhuh oderxu vxsso ghshqgv rq frqvxpswlrq dqg qhw zdjh1 hodvwlflw ri oderxu vxsso lv 1 Wkh zdjh 515 Wkh up Ohw*v orrn dw wkh ehkdylrxu ri d frvw plqlplvlqj up1 Wkh up kluhv oderxu/ surgxfhv dqg vhoov surgxfwv lq d prqrsrolvwlfdoo frpshwlwlyh jrrgv pdunhw1 Wkh up surgxfhv d vlqjoh jrrg zlwk oderxu l dqg sd v zdjhv w shuxqlwri oderxu1 Lq hdfk shulrg wkh up plqlplvhv d frvw ixqfwlrq1 45 4? w l +5165,

15 vxemhfw wr wkh surgxfwlrq whfkqrorj ' Al ; +5166, zkhuh A vwdqgv iru whfkqrorjlfdo ghyhorsphqw dqg lv ghqhg dv A ' že WTime 1 Zh dvvxph wkdw surgxfwlrq whfkqrorj lv d FreeGrxjodv surgxfwlrq ixqfwlrq zlwkrxw fdslwdo dqg frqvwdqw uhwxuqv wr vfdoh1 Zh dovr dvvxph wkdw wkhuh lv qr sxeolf surgxfwlrq1 Wklv phdqv wkdw zh dvvxph wkdw sulydwh dqg sxeolf vhfwru surgxfwlylw duh hxdo1 Wkh up grhv qrw pdnh dq surw1 Wkh surgxfwlrq ixqfwlrq dovr ghqhv oderxu ghpdqg l D ' y 1 Wkh frvw plqlplvdwlrq lpsolhv A wkh iroorzlqj uhdo pdujlqdo k y l w A ' w A mc : Wkh hxloleulxp zdjh lv jlyhq e wkh oderxu vxsso hxdwlrq 5164 dqg oderxu ghpdqg hxdwlrq Zh vxevwlwxwh wkh hxloleulxp zdjh w ' c y E A 3 lqwr wkh pdujlqdo frvw hxdwlrq 5167= c y A A E 3 ' mc : +5168, Wdnlqj qdwxudo orjdulwkpv ri hxdwlrq 5168 lhogv *? E n *?A n *? c *? E '*?mc : +5169, Wkh hxdwlrq 5169 krogv dovr lq wkh vwhdg vwdwh1 Lq rughu wr orj0olqhdulvh zh vxewudfw wkh vwhdg vwdwh ydoxhv dqg zulwh d*? *? on d*? c *? c o +516:, *? E n *?E '*?mc *? mc : Uhzulwlqj wkh hxdwlrq 516: e xvlqj qrwdwlrq e '*? lhogv e n ec E e ' fmc : +516;, Zh vxevwlwxwh wkh uhvrxufh frqvwudlqw ec ' c e g c eg lqwr hxdwlrq 516; dqg zh jhw wkh pdujlqdo frvw hxdwlrq zulwwhq dv ghyldwlrqv iurp wkh vwhdg vwdwh ydoxhv y n e g eg E e ' fmc : +516<, c c D prqrsrolvwlfdoo frpshwlwlyh up lv iuhh wr vhw dq sulfh lw zdqwv dqg wr surgxfh dq xdqwlw lw lv deoh wr surgxfh1 Dq lqyhuvh vxsso ixqfwlrq phdvxuhv wkh sulfh wkdw pxvw suhydlo iru d up wr vxsso d jlyhq dprxqw ri rxwsxw1 Wkh vxsso ixqfwlrq jlyhv wkh surw pd{lplvlqj rxwsxw dw hdfk sulfh1 Dv wkh rxwfrph ri surw pd{lplvdwlrq/ wkh uhdo pdujlqdo frvw lv vhw hxdo wr 46

16 pdun0xs lq hxloleulxp 9 1 Qrz zh fdq xvh wkh hxdwlrq 516< dqg wkh vwhdg vwdwh frqglwlrq wr zulwh wkh vxsso ixqfwlrq dv *? y W ' g c n *? g n n n *? A n n *? E ; +5173, c c c zkhuh y W lv wkh h{leoh sulfh ohyho ri rxwsxw zklfk zh fdoo srwhqwldo rxwsxw1 Qrz wkh ohyho ri srwhqwldo rxwsxw lq hfrqrp lv dhfwhg e wkh vfdo yduldeohv/ jryhuqphqw frqvxpswlrq dqg wd{dwlrq/ wrjhwkhu zlwk whfkqrorj 1 Dq lqfuhdvh lq jryhuqphqw frqvxpswlrq zloo h{sdqg surgxfwlrq srvvlelolwlhv1 D ghfuhdvh lq wd{dwlrq zloo dovr lqfuhdvh srwhqwldo rxwsxw/ vlqfh wkh krxvhkrog lv pruh zloolqj wr vxsso pruh oderxu1 Wkh srwhqwldo rxwsxw hxdwlrq 5173 krogv dovr lq wkh vwhdg vwdwh1 Lq rughu wr ghulyh wkh sulflqj hxdwlrq ri wkh up/ zh xvh Urwhpehuj +4<;5d/ 4<;5e dqg 4<;:, sulflqj dqg d frvw plqlplvlqj up*v ehkdylrxu1 Lq wkh prgho zh dvvxph wkdw wkhuh h{lvw frvwv wr wkh up zkhq lw fkdqjhv sulfhv1 Wklv dvvxpswlrq zloo lqwurgxfh sulfh vwlfnlqhvv dqg uh hfw wkh hpslulfdo dvshfw wkdw lqglylgxdo sulfh vhwwlqj lv oxps 1 Lw lv srvvleoh wr wdnh xdgudwlf dssur{lpdwlrq ri up*v surwv durxqg P W / zklfk lv d sdwk ri sulfhv d up zrxog fkdqjh li wkhuh zrxog qr eh frvwv ri fkdqjlqj sulfhv1 Wkhq d iruzdug0orrnlqj up vhwv sulfhv e plqlplvlqj d xdgudwlf orvv ixqfwlrq "[ k 2 E j E*? P nj *? P nj3 2 n a *? P nj *? P W l 2 / +5174, nj j'f zkhuh ' ;r > f lv wkh glvfrxqw idfwru dqg a lv wkh dgmxvwphqw frvw Enr sdudphwhu1 Wkh kljkhu wkh a lv/ wkh pruh frvwo lw lv wr fkdqjh sulfhv1 Wkh uvw rughu frqglwlrq lv *? P ' nan *? P 3 n nan E a *? P n n na n *? P W : +5175, Wkh fxuuhqw sulfh ohyho lv wkh zhljkwhg dyhudjh ri wkh sdvw sulfh ohyho/ wkh h{shfwhg ixwxuh sulfh ohyho dqg ri P W 1 E ghqrwlqj lq dwlrq '*?p *? p 3/ zh fdq uhzulwh hxdwlrq 5175 wr lhog ' E n a E*? P *? P W : +5176, Qrwh wkdw wkh orqj0uxq sulfhv *? P W duh ghwhuplqhg e wkh pdujlqdo frvw/ zklfk lv lq uhdo whupv *? P W *? P ' mc 1 Orj0olqhdulvlqj wklv dqg hxdwlrq 5176 zh jhw e ' E e n n a E fmc : Wkhq xvlqj wkh pdujlqdo frvw hxdwlrq 516< zh fdq zulwh wkh Skloolsv fxuyh lq whupv ri ghyldwlrqv iurp wkh vwhdg vwdwh e ' E e n n a y n e g eg E e : +5177, c c 9 Lq hxloleulxp wkh qrplqdo pdujlqdo frvw lv hxdo wr wkh qrplqdo sulfh dqg pdun0xs1 Lq uhdo whupv wklv lv œ 4 /zkhuhœ lv wkh pdun0xs1 Wdnlqj orjv/ zh fdq zulwh oq oq œ1 Krzhyhu/ wkh pdun0xs grhv qrw ghyldwh durxqg wkh vwhdg vwdwh lq hxloleulxp1 Khqfh/ zh fdq vhw 47

17 Uhzulwlqj hxdwlrq 5177 e xvlqj qrwdwlrq e '*? dqg xvlqj wkh vwhdg 0vwdwh frqglwlrq ri hxdwlrq 5173/ zh fdq zulwh wkh h{shfwdwlrqv/ whfkqrorj dqg wd{ dxjphqwhg Skloolsv fxuyh ' E n n a y n *? g *? g +5178, c c E n *?A *? E o ; zklfk fdq eh zulwwhq zlwk wkh khos ri srwhqwldo rxwsxw y W ghqhg e hxdwlrq 5173 dw wlph dv ' E n n a y n E*? *? y W ; +5179, c zklfk lv wkh Qhz Nh qhvldq vxsso fxuyh1 Qrz/ fxuuhqw lq dwlrq ghshqgv rq h{shfwhg ixwxuh ydoxhv ri lq dwlrq/ qrw rq sdvw lq dwlrq1 Wkh prgho kdv d uhvhpeodqfh zlwk Zrrgirug +4<<<,/ zkhuh kh srlqwv rxw wkdw wkhuh lv dq lpsruwdqw g qdplf olqn iurp h{shfwdwlrqv ri wkh ixwxuh wr wkh suhvhqw iru erwk lq dwlrq dqg rxwsxw1 Ohrqj +5335, qgv vxssruw wr wkh iruzdug orrnlqj Qhz Nh qhvldq prgho iurp vlpxodwlrq h{huflvhv1 Xqolnh Zrrgirug +4<<<,/ zh wuhdw srwhqwldo rxwsxw y W hqgrjhqrxvo lqvwhdg ri dvvxplqj wkdw lw lv dq h{rjhqrxv glvwxuedqfh1 Dv vfdo srolf dhfwv srwhqwldo rxwsxw/ lq dwlrq zloo dovr uhdfw wr vfdo srolf 1 Odwhu zh frpsduh wkh uhvxowv zlwk hqgrjhqrxv srwhqwldo rxwsxw zlwk wkrvh rewdlqhg zkhq srwhqwldo rxwsxw lv h{rjhqrxv1 516 Wkh jryhuqphqw Zh frqvwuxfw wkh lqwhuwhpsrudo exgjhw frqvwudlqw iru srolf dxwkrulw / olqnlqj ghew dqg srolf fkrlfhv1 Zh zulwh wkh qrplqdo jryhuqphqw rz exgjhw frqvwudlqw dv iroorzv B n Y n M M 3 'EnR 3 B 3 n G ; +517:, zkhuh B ghqrwhv jryhuqphqw erqgv/ Y wd{ uhyhqxh/ M qrplqdo prqh edodqfhv dqg G qrplqdo jryhuqphqw vshqglqj1 Jryhuqphqw srolf lv fkdudfwhul}hg e vhxhqfhv ri wd{ udwhv rq oderxu/ d vhxhqfh ri wrwdo oldelolwlhv dqg d vhxhqfh ri jryhuqphqw frqvxpswlrq1 Glylglqj hxdwlrq 517: e P jlyhv b n n M M 3 P P 3 'EnR 3 b 3 n g : +517;, P Hxdwlrq 517; vlpsolhv zkhq zh xvh wkh vdph dssur{lpdwlrq dv ehiruh iru wkh uhdo lqwhuhvw udwh E n r 'EnR E E n1 Wkh uhdo rz exgjhw frqvwudlqw lv b n n m 3 n m m 3 'Enr 3 b 3 n g : +517<, 48

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