Ebook Cyclical Government Spending, Income Inequality and Welfare in Small Open Economies
This paper is motivated by an empirical observation which appears, on the surface, to be counter—intuitive: the evidence of pro-cyclical fiscal behavior noted in a variety of studies (for examples, see Talvi and Végh (1996) for Latin America, Thornton (2008) for Africa, Lane (2003) for the OECD, and Ilzetski and Végh (2008) for developing countries). These studies point to the prevalence of pro-cyclical behavior. One could perhaps rationalize the procyclical behavior over the course of a normal cycle as follows: when economic times are good, citizens expect a dividend in terms of higher spending in the form of more and better entitlement programs and when times are bad, they understand the inevitable belt-tightening that must take place. But, a stronger case can be made for counter-cyclical government spending behavior. Pro-cyclical government spending in the expansionary phase of the business cycle could exacerbate inflationary pressures, while pro-cyclical government spending policy during the contractionary phase of the business cycle could be welfare-reducing. In contrast, counter-cyclical fiscal behavior during boom (bust) times could serve as a stabilizing influence on the economy. Why then do we observe pro-cyclical fiscal behavior?
The aim of the paper is to examine whether a case—such as reducing income inequality—can be made to support pro-cyclical fiscal policy, especially for small open economies. The decision to work with an open rather than closed economy model reflects the importance of global shocks. This paper assesses the implications of cyclical fiscal spending policy for the case of a productivity shock, a domestic interest rate shock as well as for the case of external shocks coming from export demand and the terms of trade.
We compare the effects of pro-and counter-cyclical government spending on welfare as well as on income distribution. The focus on income inequality is particularly important for fiscal policy, because changes in fiscal policy have distributional implications (see for examples Heathcote (2005), Heathcote, Storesletten and Violante (2009) and Kumhof and Laxton (2009)). Like these studies, we examine the cyclicality of government spending, but we embed the dynamics of income distribution across agents into a standard stochastic dynamic general equilibrium aggregate open-economy model, following the approach put forward by Correia (1999), García-Peñalosa and Turnovsky (2007) and Turnovsky and García-Peñalosa (2007) in their use of Gorman preferences. The advantage of this is that the fiscal policy is discussed in a more widely used type of macroeconomic model, namely one with Calvo pricing and inflation targeting.
The paper is organized as follows. Section 2 describes the extension of a standard dynamic stochastic general equilibrium small open economy model to allow for heterogenous households with Gorman preferences. Since we explore the effects of fiscal policy under external export and terms of trade shocks, the model contains two production sectors a tradeable goods sector which draws on natural resources and produces goods for domestic and foreign consumption, and a non-tradeable goods sector which imports intermediate goods and combines them with labour to produce goods for domestic private and public consumption. Prices in the tradeable goods sector are determined globally while prices in the non-tradeable goods sector follow typical Calvo-pricing rules. The model also includes a financial system which accepts deposits from households, borrows internationally, and lends to the government and to domestic firms. We thus combine financial frictions with nominal rigidities. This more extensive specification permits examination of domestic financial shocks as well as the usual shocks to exports, export pro-ductivity or terms of trade. Section 3 discusses the calibration. The model is solved using the software DYNARE (see Julliard, 1996 for description of method).
Section 4 contains two sets of simulated results. The first subsection contains the impulse response paths of the aggregate variables, as well as the distribution of welfare for both pro- and counter-cyclical government spending under alternative shock scenarios. The second subsection discusses the extension of standard DSGE modeling to the case where heterogeneity is explicitly modelled to facilitate the generation of measures of income inequality. We measure inequality in two ways: the Atkinson Inequality Index and the Deaton-adjusted Gini coefficients. This section is devoted to showing the effects of the alternative public spending rules, also under different stochastic scenarios, on income inequality. Concluding remarks are in the final section.
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