FISCAL POLICY AND MACROECONOMIC FLUCTUATIONS IN A FIXED EXCHANGE RATE REGIME

Chung-Fu Lai¹

¹Department of Applied Economics, Fo Guang University, Yilan County, Taiwan

Keywords:Fiscal policy Consumption home bias Fixed exchange rate regime Macroeconomic fluctuations New open economy Macroeconomics.

ARTICLE HISTORY: Received:21 May 2018. Revised:14 August 2018. Accepted:17 September 2018. Published:30 October 2018.

Contribution/ Originality:This study provides a detailed account of how government spending shock on macroeconomic fluctuations under the fixed exchange rate regime. We found that the role of consumption home bias affects the effects of government spending shock on macroeconomics variables in the long and short term.

1. INTRODUCTION

Traditional Keynesian economics believes in fiscal policy is an effective means for counter-business cycle. However, in fact the government wants to show its prominent position in economic regulation, so its fiscal operation is very aggressive. Every school of thought has a different point of view on the effect of fiscal policy on output, consumption, interest rate and price. As far as public spending is concerned, Keynesian economics thought expansion of public spending will increase output and then increase private investment. On the one hand the increased price and interest rate will crowd out private investment, thus the effect of private investment is not certain. As to private consumption, it has to be decided by the marginal consumption propensity and its response to the interest rate. In the opinion of Classical School, fiscal policy only influenced nominal variables but not real variables. The increased government spending just raised the price. Moreover, New Classical School stressed that the provisional and permanent government spending would have different effects on macroeconomic. In addition, Supply-side economics was in a favor of tax cuts policy, it thought an incentive would be given and had an increased saving and investment in order to stimulate total supply and decrease inflation rate and reduce unemployment rate. Whatever in the theoretical or empirical aspect, fiscal policy on the effect of macroeconomic variable both shows a lot of difference.

Besides, the exchange rate represents the relative price of domestic currency and foreign currency, which assumes the responsibility of association with home economics and foreign economics and facilitation for internal and external equilibrium. In these literatures, the effect of fiscal policy on floating exchange rate regime has widely discussed (for instance, (Pitterle and Steffen, 2004a;2004b ; Tervala, 2008 ; ANYANWU et al., 2017 ; Hsiao et al., 2017 ; Liu et al., 2017 )). However, under the fixed exchange rate system, the exchange rate cannot provide the function of transmission, then what effect fiscal policy will have on the macroeconomic variables lacks a complete discussion. In addition, consumption home bias is a common phenomenon in the society, which explains consumers usually are inclined to have a preference for domestic goods. Therefore, this paper tries to analyze the fiscal expenditure shock on macroeconomic variables under the fixed exchange rate system and make a statement of the role of consumption home bias.

Many literatures focused on the effect of fiscal policy on macroeconomic in closed economy (for example, (Barro, 1981;1990 ; Futagami et al., 1993 ; Devereux and Love, 1995 ; Greiner, 1998 ; Greiner and Hanusch, 1998 ; Dasgupta, 1999 ; Xie et al., 1999 ; Sa’idu, 2014 ; Cieslak and Povala, 2015 ; Shiamptanis, 2015 ; Musti, 2016 ; Nakata, 2017 )). The analysis of fiscal policy on open economy does not have many talks. Until in recent years “New Open Economy Macroeconomic (hereinafter referred to as NOEM)” rises suddenly, for instance, Corsetti and Pesenti (200 1); Ganelli (2003 ) and Pitterle and Steffen (2004a;2004b ) in succession extended their research to fiscal policy on the effect of open economy. However, in a traditional NOEM model the main cause of exchange rate volatility is private sector consumption, hence the interested topic turns to be under the fixed exchange rate system if government spending is included in consumption and both private and government consumption have a home bias in consumption, then what effect on macroeconomic will have. Therefore, the purpose of this paper is to discuss the relationship among government spending, consumption home bias and macroeconomic variable. Tervala (2008 ) talked about the effect of fiscal policy under the framework of NOEM and got a result that the marginal rate of substitution of private consumption and government spending are the most important reason which affects fiscal spending on the effect of welfare but it also ignores a popular issue, namely, consumption home bias. Besides, Chang and Liu (2018 ) construct a simple dynamic general equilibrium model to examine how the active monetary and passive fiscal policy affect interest rates and inflation rates. Cebi and Culha (2014 ) investigate the effects of government spending shocks on the real exchange rate and foreign trade balance in Turkey within a structural VAR framework.

Initial Open economy analysis development is extended from Mundell-Fleming Model see (Fleming, 1962 ; Mundell, 1963 ) and Dornbusch (1976 ) based on Keynesian doctrine. In spite that these open macroeconomic models explain the relationship among some macroeconomic variables, but all of them have one shortcoming, that is, lack of micro-foundation. Lucas (1976 ) had a view that macroeconomic variable change will affect individual’s decision in micro economy and such makes a change in the relationship among macroeconomic variables which produces deviation from macroeconomic analysis with the lack of micro-foundation. In the end the birth of NOEM starts a new development phase for open macroeconomic. NOEM is a new generation research method for open economy, it features both micro-foundation and the framework of monopolistic competition and it is suitable for the analysis of external shock on macroeconomic. Accordingly, this research builds its foundation on NOEM.

Nevertheless, it should be noticed that although Obstfeld and Rogoff (2000 ) considered “home bias in consumption puzzle” as one of six puzzles in International Economics.¹ But under the framework of NOEM the discussion about asymmetry in the role of home bias in consumption still are not enough. The so called consumption home bias puzzle means in the society consumers are inclined to have a preference to home goods, but the phenomenon in the market cannot be explained by researchers. Some research about it mainly focus on its origin, for example trade cost (Obstfeld and Rogoff, 2000 ; Ried, 2009 ) the country size and openness (Sutherland, 2005 ; Paoli, 2009 ) non-traded goods (Stockman and Dellas, 1989 ; Pesenti and Wincoop, 2002 ) and trade in intermediate factors input (Hillberry and Hummels, 2002 ) which all result in consumption home bias. But recent research stress on discussion of its effect. For example, Pierdzioch (2004 ) studied the effects of monetary shock under consumption. Hau (2002 ); Kollmann (2004 ); Sutherland (2005 ); Leith and Lewis (2006 ) and Cooke (2010 ) explored home bias on the effect of exchange rate, Paoli (2009 ) discussed the welfare effect of monetary policy with consumption home bias. Another issue needs to mention about is home bias on the effect of formulation of the optimal monetary policy, related research including Faia and Monacelli (2006 ); Jondeau and Sahuc (2008 ); Gali and Monacelli (2008 ) and Wang (2010 ). Angrick (2018 ) examined the monetary policy constraints facing economies on a fixed peg or managed float regime, Bajo-Rubio and Diaz-Roldan (2016 ) presented a novel framework to include a monetary policy rule instead of the LM function together with an aggregate supply function derived from the Phillips curve, Ca’Zorzi et al. (2017 ) found that the root cause is its inability to predict domestic and foreign inflation, and Kolasa and Rubaszek (2015 ) compared the quality of forecasts from DSGE models with and without financial frictions. Obviously, there are plenty of related researches but at present no article can clarify its role in the effect on fiscal spending under the fixed exchange rate. Hence this paper wants to make a breakthrough

This paper separates into 4 sections. Except for introduction, other sections are as follows: Section 2 builds a theoretical model, Section 3 is simulation analysis which discusses the effect of fiscal spending on macroeconomic variables in the long run and short run under the fixed exchange rate regime, and the role of consumption home bias, and Section 4 is conclusion and suggestion.

2. THEORETICAL MODEL

2.1. Model Setting

This paper follows NOEM proposed by Obstfeld and Rogoff (1995 ) as a theoretical basis; the main assumptions are stated as follows:

1. There are two countries in the world, “home country” and “foreign country”, all of the following foreign economic variables are marked as “*” for identification.
2. World population is distributed within the interval of [0,1], where individuals of home country are distributed between [0,n) and foreign individuals are distributed between [n,1].
3. Each individual is both consumer and producer, and he operates a monopoly competitor factory uses labor for production.
4. Consumption home bias behavior exists in economic system and government spending is the only exogenous shock.
5. Fixed exchange rate regime is implemented domestically.
6. The price featured with stickiness and is not adjustable in the short term, but can be freely adjusted in the long term steady state.

2.1.1. Household

Assuming that all individuals have the same preferences, utility ( U ) is a function to the consumption ( C ), real money balances ( M / P) and output level ( Y ) , the lifetime utility function is set as follows:

2.1.2. Government

The government spending can be financed by seigniorage revenue and lump-sum tax, so the government budget constraint is:

Where the item at the left of the equation is real government spending; the first item at the right of the equation is real tax revenue and the second item at the right of the question is real seignorage revenue.

Assume that both the government sector and private sector have the same preferences, the government spending follows CES function as:

2.1.3. Asset Market
Assuming that there is an integrated international capital market between the two countries, either of which can trade real bonds ( B ) in the market, and the relationship between the bond maturity real interest rate ( r ) and nominal interest rate ( i ) is based on the Fisher equation, expressed as:

Where B stands for the bond possession volume of the representative domestic individual, while B^*stands for the bond possession volume of the representative foreign individual.

2.1.4. Budget Constraint

The budget constraint of representative individual is expressed as:

2.1.5. Aggregate Demand

From Eqs. (7) and (9), demand on the goods that domestic manufacturers face can be expressed as:

2.1.6. First Order Conditions

Under the budget constraint (Eq. (14)), the first-order conditions of utility (Eq. (1)) maximization is expressed as:

Where Eq. (17) is the Euler Equation of consumption, which describes the intertemporal consumption behaviors, Eq. (18) is the equation of money demand for indicating the substitution relation between real money demand and consumption, Eq. (19) is the labor supply equation which stipulates the substitution relation between labor supply and consumption.

Discussed in the following paragraphs are the effects of government spending shock on macroeconomic variables. To begin with, the initial state (0 steady state) is given, assuming that consumption home bias and government spending shock do not exist in the economic system. The initial state will then be used a baseline for comparison, so as to derive the economic system’s long-term steady state. For analysis of long-term steady state, the symbols used are the subscript “ t ” which indicates the macroeconomic variables under the long-term steady state, and subscript “ 0 ” which indicates the macroeconomic variables under the initial state. For example, C_t and C₀  represent the consumption levels under the long-term steady state and initial state, respectively. For analysis of short-term steady state, however, the macroeconomic variables under the long-term steady state are denoted without the subscript symbols, while the subscript “ t ” is used to distinguishingly denote the values of macroeconomic variables under the short-term steady state.

By substituting the government budget constraint (Eq. (11)) to the private budget constraint (Eq. (14)), and assuming that B_t-1 = 0, the following equation is obtained:

2.3. Log-Linearization

To get a closed-form solution, this paper has used the approach suggested by Uhlig (1995 ). The model was first given the log-linearization process and then its parameters are given values for simulation analysis.¹ The variables are then given the log-linearization process near the initial state to obtain their volatility.

 We use the log linearized price index (Eqs. (22) and (23)), the log linearized law of one price (Eqs. (25) and (26)), the log linearized world consumption (Eq. (28)), the log linearized demand function (Eqs. (29) and (30)), the log linearized labor supply function (Eqs. (31) and (32)), the log linearized terms of trade (Eq. (36)), and log linearized private budget constraints (Eqs. (37) and (38)) to require a solution to get the equation expressing the relationship with 13 endogenous and exogenous variables, which are domestic consumption

3. THE EFFECTS OF FISCAL POLICY ON MACROECONOMIC FLUCTUATIONS

In order to get the change of consumption home bias parameter on the effect of fiscal expenditure, this paper goes on simulation analysis.

3.1. Parameterisation

For the purpose of simplification, this paper based on NOEM selects two economics of equal size as subjects (see Lubik and Schorfheide (2005 )). Therefore, in the selection of parameter, we try to introduce some empirical evidence of US and other countries of equal size (for example, OECD countries, European Union) to analyze the effect of fiscal expenditure in US and other countries. We follow assumptions of Bergin et al. (2007 ) that had given the elasticity of substitution of product between countries,

Table-1. Selection of Parameters

3.2. Simulation and Comparative Static Analysis

This section use the above parameter to go on simulation in order to discuss the effects of fiscal expenditure on exchange rate, price, consumption, output, and terms of trade. The result is stated in Table 2.

Table-2. The Long-Term Effect of the Fiscal Policy on the Macroeconomic Variables

From Table 2 (a) to (l) we know that in the long term except that fiscal expenditure is negatively correlated with terms of trade and its relationship with other variables will be affected by asymmetry of consumers’ preference to goods. Among them except for “consumers in both countries have a preference to domestic goods”, the increase in fiscal expenditure will result in an increase in domestic consumption and a decrease in domestic output, in other conditions, an increase in fiscal expenditure will result in a decrease in domestic consumption and an increase in domestic output. The relationship of fiscal expenditure and price index, except for conditions such as “consumers in both countries have a preference to domestic goods”, “domestic consumers have no consumption bias , but foreign consumers have a preference to domestic goods”, and “foreign consumers have no consumption bias, but domestic consumers have a preference to domestic goods”, an increase in fiscal expenditure will raise the domestic price, in other conditions, an increase in fiscal expenditure will result in a decrease in domestic price index.

The intuition behind the above conclusion can be explained as: without consideration of consumption bias, an increase in government expenditure will increase demand for domestic goods and so increase domestic output, but because of crowding out effect, which will decrease private consumption, and deteriorates terms of trade; in consideration of asymmetry of consumption bias, like the condition that “consumers in both countries have a preference to domestic good”, the relationship of government expenditure, consumption, output and price will appear inverted.

In the short term equilibrium, the results of simulation and comparative static analysis are listed as Table 3. From Table 3, in the short term because there is a rigidity about the price,

Table-3. The Short-Term Effect of the Fiscal Policy on the Interest Rates

4. CONCLUSION AND SUGGESTIONS

It has been 23 years since NOEM is found, however compared to the universal research in monetary shock, research in connection with the effect of fiscal expenditure is not enough. In view of the aforementioned reason, this paper under the framework of NOEM model by Obstfeld and Rogoff (1995 ) brings consumption home bias into the model to discuss under the fixed exchange rate system, when a country faces a fiscal expenditure shock, how the role of consumption home bias plays on the effect of macroeconomic variables.

By way of theoretical derivation and simulation analysis, this paper discovers an increase in fiscal expenditure will deteriorate terms of trade, as to the relationship of fiscal expenditure and other variables (for instance, consumption, output, price) will be affected by asymmetry in consumers’ preference to goods in both countries, in the short term an increase in fiscal expenditure will raise the interest rate, but with the rigidity of the price, fiscal expenditure will not have a effect on consumption, output, price, terms of trade and current account.

At last, we want to stress the point that the framework of NOEM model exerts itself on lots if economic issues, but in fact for the purpose of simplification, it is usually build on many assumptions. If we want to release one of assumption, we will have a different result. This shortcoming is included in the limitation of this paper.

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₂ The elasticity of marginal utility of real money balance () is defined as the response of the change in the marginal utility of real money balances under a change of real money balances.