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
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
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Tobin (1955): The first DGE model of cycles?
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A “Solow” model
Exogenously fixed nominal wage
Result: Increase in G crowds out I one-for-one
Has no effect on Y
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Modern literature adds a lot
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•
•
•
Consumer optimization
Natural rate property
Rational expectations
Sticky prices instead of wages
We show: The upshot is now that Y falls if G rises
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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?
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Building blocks of the model
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•
•
•
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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
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Why are “good” real shocks contractionary
in the baseline model?
Cobb-Douglas production:
Y  ZK  N 1  F
First-order condition:
1 Y F
r

 (.) K
where  is the ex post markup
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“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)
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•
•
•
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
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KE-LM diagram
r
r
1 YF
 (.)

LM
K
KE
KE’
Y
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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
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Baseline model results
FIGURE 1. BASELINE MODEL (cont'd)
OUTPUT
G
1.5
5
1
4
0.5
3
0
2
-0.5
0
100
200
300
400
100 periods=1year
500
1
0
100
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200
300
400
100 periods=1year
500
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Baseline model results, cont’d
FIGURE 1. BASELINE MODEL
OUTPUT
HOURS
1.5
1.5
1
1
0.5
0.5
0
0
-0.5
0
100
200
300
400
100 periods=1year
500
-0.5
0
100
INVESTMENT
200
300
400
100 periods=1year
500
CONSUMPTION
0
0
-1
-0.1
-2
-0.2
-3
-0.3
-4
-5
0
100
200
300
400
100 periods=1year
500
-0.4
0
100
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300
400
100 periods=1year
500
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Flex-price version has similar problems
FIGURE 3. BASELINE FLEX-PRICE MODEL
OUTPUT
HOURS
1.5
1.5
1
1
0.5
0.5
0
0
-0.5
0
100
200
300
400
100 periods=1year
500
-0.5
0
100
INVESTMENT
0
-1
-0.1
-2
-0.2
-3
-0.3
-4
-0.4
100
200
300
400
100 periods=1year
500
CONSUMPTION
0
-5
0
200
300
400
100 periods=1year
500
-0.5
0
100
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200
300
400
100 periods=1year
500
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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?
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Implications of KPR utility

U  e
t 0
 t
11 
t
C
1  1v Nt 
e
1 1 
 ln  Ct     rt     1     ln v  Nt 
   rt     1     ln  Nt 

 WN 
where   
  0.8 in U.S. data
 C 
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Will KPR + higher-order costs fix?
 ln  Ct     rt     1     ln  Nt 
• 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
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Sticky-investment model with low IES
FIGURE 4. STICKY-INVESTMENT MODEL WITH LOW IES (cont'd)
OUTPUT
G
5
2
1.5
4
1
3
0.5
2
0
-0.5
0
100
200
300
400
100 periods=1year
500
1
0
100
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300
400
100 periods=1year
500
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Sticky-investment model with low IES, cont’d
FIGURE 4. STICKY-INVESTMENT MODEL WITH LOW IES
OUTPUT
HOURS
2
2
1.5
1.5
1
1
0.5
0.5
0
0
-0.5
0
100
200
300
400
100 periods=1year
500
-0.5
0
100
INVESTMENT
200
300
400
100 periods=1year
500
CONSUMPTION
0
0.5
-1
-2
0
-3
-4
-5
0
100
200
300
400
100 periods=1year
500
-0.5
0
100
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300
400
100 periods=1year
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Need for cyclical markups (e.g., sticky prices)
FIGURE 5. FLEX-PRICE STICKY-INVESTMENT MODEL WITH LOW IES
OUTPUT
HOURS
2
2
1.5
1.5
1
1
0.5
0.5
0
0
-0.5
0
100
200
300
400
100 periods=1year
500
-0.5
0
100
200
300
400
100 periods=1year
INVESTMENT
CONSUMPTION
0
0
-1
-0.1
-2
-0.2
-3
-0.3
-4
-0.4
-5
0
100
500
200
300
400
100 periods=1year
500
-0.5
0
100
200
300
400
100 periods=1year
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Why KPR and not RoT?
ct    rt     1    nt
• 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?
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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.)
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