In this paper we have examined the interactions of fiscal and monetary policies in a monetary union. One main focus was to derive a theoretical model that allows for capturing heterogeneities among the different countries participating in a monetary union, and for analyzing strategic interactions of fiscal and monetary authorities. Why do heterogeneities matter? The answer is relatively simple. By adopting the Euro, the participating countries abstain from a monetary policy of their own and fiscal policy remains the only instrument for pursuing specific goals and stabilizing region-specific shocks. The common central bank has to implement a monetary policy that is most appropriate for the whole monetary union, and cannot respond to idiosyncratic shocks and country-specific political targets. This makes the role of fiscal policies more important and leaves room for strategic behavior in achieving national goals.
To examine these heterogeneities we have enhanced the model of Dixit and Lambertini (2003b). From the microfoundation we have established that a region-specific produc-tivity shock and terms of trade have an impact on regional output. In Section 2.3 we introduced different possible scenarios for strategic interactions between fiscal and monetary policies. In this context we assumed that fiscal policies deviate from opti-mizing regional welfare, aiming instead at higher inflation and output compared to
the union-wide central bank. By contrast, monetary policy is assumed to maximize union-wide welfare.
We have used simulations to evaluate the different scenarios of strategic behavior for supply-side fiscal policies in line with the micro-model. These aim at granting subsi-dies to increase output financed by per-capita taxes. We have thus considered a het-erogeneous monetary union comprising two different regions: a “conservative region”
and a “catch-up” region. We have assumed that the desired inflation and output targets of the “conservative region” are relatively closer to the social optimum.
To evaluate the different policy games, we have used a calibration of our micro-model drawing upon the parameters from the standard economic literature. We have shown that the losses of fiscal policies are relatively small in the Nash scenario, in the fiscal leadership scenario (for both cooperation of fiscal policies and independently acting fiscal policies), and when fiscal policies cooperate and all policy makers move simul-taneously. In these scenarios, fiscal policies achieve an output level closest to their preferred levels, whereas inflation is stabilized close to the socially optimal level by the common central bank.
The losses of monetary policy, which correspond to the welfare losses of the private agents, are lowest when monetary policy moves first. The first-best situation is attained when all policy makers agree upon the socially optimal levels. But as the central bank and fiscal policy makers consider different scenarios optimal such, an agreement ap-pears to be unrealistic on a voluntary basis.
In the EMU, fiscal policies appear primarily to track national interests. However, the analysis has shown that fiscal policies in a heterogeneous monetary union can con-tribute to high welfare losses. From a welfare perspective, monetary leadership or co-operation would then be a desirable scenario for both types of fiscal policy.
To summarize the main findings, we state that if the authorities’ preferences do not coincide, or are at least relatively far apart, worse outcomes are likely to occur. In such a case, designing the institutions so that monetary policy plays a lead role generates the smallest losses for the agents living in both regions, even with existing heterogeneities.
The European Central Bank aggressively pursues the price-stability goal, meaning that the inflation rate should not exceed 2%. Accordingly, it appears to act as a first mover, which is beneficial for welfare. At the same time, fiscal policies are restricted in their actions by the Stability and Growth Pact, which leaves less room for pursuing excessive fiscal targets and implies a reduction of the trade-offs caused by strategic behavior.
Recent experience, however, has shown that in bad times meeting the stability criteria may not be a very credible option for fiscal policies, especially, when the culprits judge their own sanctions, as it has happened in the European Union. Therefore, reducing heterogeneities and bringing fiscal policies’ targets closer to the socially optimal levels is an essential task in achieving a longer-term stability guarantee for the EMU.
with Harald Uhlig
Is it possible to explain the house price to GDP ratio and the house price to stock price ratio as being generally constant, deviating from its respective mean only because of shocks to productiv-ity. We build a two-sector RBC model for residental and non-residental capital with adjustment costs to capital in both sectors. We show that an anticipated future shock to trend productivity in the non-residental sector leads to a large increase in house prices in the present. We use this property of the model to explain the current house price behavior in the U. S., the U. K., Japan and Germany.
3.1 Introduction
Many researchers and practitioners are puzzled by the developments in the real es-tate market prior to the downturn in 2006. While countries such as the U.S., Spain or the U.K. experienced high growth rates in real estate prices, real estate prices did not grow at all or even fell in countries like Japan, Germany and Switzerland. This may ex-plain the growing interest of researchers in understanding the real estate market in the recent years, even before the beginning of the current recession. While European Cen-tral Bank (2003) and International Monetary Fund (2004) report some stylized facts for real estate prices – they co-move with GDP, but are lagging, more volatile and do have longer cycles of more than ten years – there is rather little understanding about the driving forces in the real estate market. This is the starting point of this paper. We lay out our theory to simultaneously explain movements in GDP, house prices and stock prices. We assume that all three variables feature the same balanced growth path. But temporary shocks may lead to deviations in the house price to GDP and the house price to stock price ratio. The main point of this paper is to show how expectations
57
about the prospects of the economy can explain an immediate rise in house prices rel-ative to stocks and GDP. We make this point by building a two-sector RBC model for non-residential capital and housing capital. Both sectors are subject to concave ad-justment costs, but only the real estate sector features a constant factor of production.
Because of the latter assumption, the relative price of real estate has a positive trend.
From a modeling perspective, this paper is related to Piazzesi et al. (2007), Benhabib, Rogerson, and Wright (1991) and Greenwood and Hercowitz (1991). While all papers have a consumption side that is comparable to our model, the first and the second paper lack an explicit production function. The second and the third paper answer a different question: They analyze the implications of non-market activities by house-holds. Nonetheless, the modeling strategy is similar in its approach.
Of course, house price movements have already been addressed in many papers. A survey article of the relevant literature can be found in Leung (2004). For this rea-son we will only briefly mention some of the papers here. Case, Glaeser, and Parker (2000), Campbell and Cocco (2005) and Iacoviello (2005) all explore the connections between real estate and consumption and their possible implications for economic (fiscal or monetary) policy. The models presented in Iacoviello (2005), Ortalo-Magné and Rady (2002) as well as Jin and Zeng (2004) and Yang (2005) all feature household heterogeneity with respect to borrowing constraints, homeownership or age. Lustig and Van Nieuwerburgh (2005) investigate the effect of changing house prices on the housing wealth to human wealth ratio in a model of housing collateral.
The effect of inflation on house prices – either as an effective tax subsidy to owner oc-cupied housing or through money illusion – is analyzed in a series of papers by Poterba (1984, 1991, 1992) and, more recently, Brunnermeier and Julliard (2008). Piazzesi and Schneider (2008) build a heterogeneous agent model in which next to the tax channel heterogeneous inflation expectations increase the volume of credit and thus the price of the collateral.
Our approach differs from most of the literature in two respects. First, we want to explain house price movements in response to changes in the macroeconomic envi-ronment. Second, instead of resorting to individual credit constraints or household heterogeneities, we consider only shocks to current and future productivity as driving forces.
The paper is structured as follows. Section 3.2 summarizes important empirical find-ings. Section 3.3 presents our main idea in a simplified endowment economy. An
elab-orated production economy, its solution and its results are dealt with in Section 3.4, followed by the conclusion in Section 3.5.