Dejan Krušec PhD Student European University Institute Rethymno, Rethymno, Outline of research in the area of EMU – Current state and future prospects

(At least) Three topics of interest: 1. Fiscal and monetary policy mix in the EMU and accession (i.e. acceding) countries 2. Exchange rate and inflation in accession countries 3. “Equilibrium” level of deficit in EMU and accession countries

Fiscal and monetary policy mix in the EMU and accession (i.e. acceding) countries Motivation: Idea: What if ECB triggers with its e.g. tight monetary policy shocks loose fiscal policy in Eurozone countries and therefore countries get into the risk of exceeding the 3% deficit bound? Even worse scenario if some countries loosen and other tighten their fiscal policy as a response. - important question for EMU: do government in response to monetary tightening tighten or loosen fiscal policy and vice versa – implications for the SGP, same question for accession countries, - distinguish comovement of the two policies over the business cycle from reaction of one the shock of the other – VAR suitable technique.

- Research background: not much VAR method research in this area, some cross-section studies, e.g. Studies of Melitz (1997) and Wyplosz (1999) find that monetary and fiscal policy tend to move in the opposite directions. Melitz (1997, 5) uses in his study two-stage least squares and three- stage least squares method the interaction on the sample of 19 OECD countries. Both authors: evidence of strategic substitutability between the two government policies i.e. looser fiscal policy promotes tighter monetary policy and vice versa. According to these studies we would e.g. expect the government spending to increase and taxation to decrease in response to tighter monetary policy i.e. in response to the increase in the interest rate - central bank’s instrument. - Research background: not much VAR method research in this area, some cross-section studies, e.g. Studies of Melitz (1997) and Wyplosz (1999) find that monetary and fiscal policy tend to move in the opposite directions. Melitz (1997, 5) uses in his study two-stage least squares and three- stage least squares method the interaction on the sample of 19 OECD countries. Both authors: evidence of strategic substitutability between the two government policies i.e. looser fiscal policy promotes tighter monetary policy and vice versa. According to these studies we would e.g. expect the government spending to increase and taxation to decrease in response to tighter monetary policy i.e. in response to the increase in the interest rate - central bank’s instrument.

Why VAR approach: better isolation of shocks and responses (because of difference between three types of e.g. fiscal shocks and responses; - first the automatic response of taxes and government spending to innovations in output, prices and interest rates, - first the automatic response of taxes and government spending to innovations in output, prices and interest rates, - then the discretionary response of fiscal policy to output prices and interest rates and finally - then the discretionary response of fiscal policy to output prices and interest rates and finally - the structural fiscal shocks, which are unlike the reduced form residuals not correlated with each other and with all other structural shocks. - the structural fiscal shocks, which are unlike the reduced form residuals not correlated with each other and with all other structural shocks.

- My previous research on fiscal-monetary policy mix for four OECD countries (Australia, Great Britain, Canada and USA) in a structural VAR framework - My previous research on fiscal-monetary policy mix for four OECD countries (Australia, Great Britain, Canada and USA) in a structural VAR framework - Method: structural VAR (five variables: output, inflation government spending, taxation, central bank’s interest rate), with the identification procedure following Blanchard and Perotti (QJE 2002):

3-step identification procedure - first step in the identification procedure - fiscal variables do not react to unexpected price or output movements within a quarter which sets the discretionary response of government spending and taxes to movement and output to zero. - first step in the identification procedure - fiscal variables do not react to unexpected price or output movements within a quarter which sets the discretionary response of government spending and taxes to movement and output to zero. - second step – automatic responses: compute price and output elasticities of taxes, and price elasticity of government spending, - second step – automatic responses: compute price and output elasticities of taxes, and price elasticity of government spending, - third step: - determine which of the two fiscal shocks comes first – Cholesky ordering, determine order of other variables. - third step: - determine which of the two fiscal shocks comes first – Cholesky ordering, determine order of other variables.

Table: Synthetic presentation of results

Findings Countries do not have the same fiscal-monetary policy mix, e.g. - fiscal and monetary policy acted as substitutes in Australia, Canada and partly in United States, - fiscal and monetary policy acted as substitutes in Australia, Canada and partly in United States, - the degree of substitutability is not higher in the period from 60s up to 1980 than after that date (from the 80s to the year 2001), - the degree of substitutability is not higher in the period from 60s up to 1980 than after that date (from the 80s to the year 2001), - Great Britain acts as an ‘outlier’ since the evidence shows that fiscal and monetary policy acted more like strategic complements, especially in the period before Great Britain acts as an ‘outlier’ since the evidence shows that fiscal and monetary policy acted more like strategic complements, especially in the period before 1980.

Alternative approach: five variable co- integrated VAR. Why? 1. Suitable framework to separate automatic responses of fiscal, monetary policy to economic activity from fiscal and monetary policy shocks (i.e. separate comovement over the business cycle from pure reactions of the two policies to each-other). We would get three co-integrating relations, one for automatic response of government spending to GDP and inflation movements, the other for automatic response of taxation to GDP and inflation movements and the money demand equation. 2. No need to get disaggregated data on taxes and government spending to compute price and output elasticities 3. It is possible to determine which of the two policies comes first i.e. is weakly exogenous with respect to the other and with respect to output and price movements. 4. Cholesky ordering of variables needed only to identify the shocks once cointegration is accounted for.

Same method for accession countries, comparison of responses, implication for ECB. Same method applied ot Eurozone as a whole with the aggregation like in e.g. Artis and Beyer (2003?), but the question of usefullness of such aggregation since no SGP before 1999, therefore variables combine differently then after 1999.

2. Exchange rate and inflation in accession countries - Well known question of how to enter into the ERM II and whether or not the Maastricht inflation criterium is too tight - Two potential problems for accession countries: 1. Balassa-Samuelson effect (driven by productivity) 2. Exchange rate pass-through (driven by inflation expectations in a small open economy) Existing studies analyse both effects separately, but no analysis of both in the same framework.

Proposed method Analyse both effects together in a co-integrated VAR framework, where we have four variables: - productivity in the tradable sector, - money supply, - money supply, - exchange rate, - exchange rate, - inflation rate (or difference of domestic and Eurozone inflation rate). - inflation rate (or difference of domestic and Eurozone inflation rate). We expect to have two cointegrating relationships, since we have a policy variable and an exogenous variable and two endogenous variables. Existing study of Coricelli et al. (2002) on exhange rate pass-through does not take into account the Balassa-Samuelson effect.

First cointegrating relation (automatic response of...): productivity combined with exchange rate and inflation rate – Balassa Samuelson effect, LR test of significance of parameteres, Second cointegrating relation: Exchange rate pass through - money supply combined with exchange rate and inflation rate (and LR test).

Possibilities of the method Checking for interdependence of the two effects in the direction that the productivity growth shock may trigger the money supply growth and exchange rate adjustment which in turn induces inflation. If this is empirically true, productivity effects inflation directly and through the monetary policy adjustment.

3. Equilibrium level of deficit in EMU and accession countries Idea: What if EMU and accession countries have different „equilibrium“ levels of deficit, what if for some countries it is nested in institutions that they have higher budget deficits in absence of any shocks, while others run balanced budgets ór even budget surpluses? - Scenario: High „equilibrium“ deficit + recession or negative supply or demand shock could mean exceeding the 3% deficit bound

Could work in the same cointegrated VAR framework with variables included: Could work in the same cointegrated VAR framework with variables included: - GDP, - Inflation, - CB‘s interest rate, - deficit. The framework allows to do the LR test whether deficit „equilibrium“ response to the GDP and inflation movements are significantly different between the countries. Additionally, we can test for responses of the deficit to the shocks in the CB‘s interest rate.