1. 1 Fiscal Policy with Credit Constrained Households Werner Roeger and Jan in ’t Veld DG ECFIN - Economic and Financial Affairs European Commission June 2009 The views expressed here are those of the author and should not be attributed to the European Commission.

2. 2 Revival of interest in discretionary fiscal policy Earlier scepticism on effectiveness of fiscal policy: Dominance of supply shocks in the past Financial liberalisation Severity of financial crisis sharp fall in aggregate demand tightening credit constraints limits of monetary policy Policy response: European Economic Recovery Plan Fiscal packages announced by EU member states : 1.1% of GDP in 2009, 0.6% of GDP 2010. G-20 : 1.8% of GDP in 2009, 1.3% in 2010 ($1.35 trl)

3. 3 Structure of the presentation 1.Literature review of fiscal multipliers 2.Empirical evidence credit constraints 3.QUEST III with credit constrained households 4.Impulse responses to government spending and tax shocks (with and without credit-constrained households) 5.The role of monetary policy

4. 4 Overview of empirical literature VARs Results in the VAR literature differ widely. The highest multipliers are obtained for US data (Blanchard and Perotti (2002)), Estimates for European data seem to be less significant (Perotti (2005), De Castro and Fernandez de Cos (2006), Afonso and Sousa (2009))

5. 5 Overview of empirical literature: DSGE models Since the result obtained by Blanchard and Perotti is often regarded as representing a stylised fact, several attempts have been made to come up with DSGE models which can generate positive consumption co-movement. –Ravn et al. (2007) introduce a market structure into the model which implies a strong decline in the mark up in the case of a government spending shock in order to generate a positive consumption effect. –Monacelli et al. (2008) introduce a utility function which implies a stronger comovement between hours worked and consumption in order to generate the same effect. –Gali et al. (2007) generate a positive effect on private consumption by introducing substantial capital market imperfections in the form of liquidity constrained households.

6. 6 Overview of empirical literature: DSGE But empirically estimated DSGE models have problems to obtain such an effect: –Ratto et al. (2009a) estimate a 1 st year multiplier for gov. cons. shocks of around 0.6 with an estimated share of liquidity constrained households of about 30% for the euro area, similar for gov. inv. but lower for transfers. But it is impossible to replicate the Gali result despite liquidity constrained consumers. –Also Coenen and Straub (2005) find for a similar share of non-Ricardian households a decline in aggregate consumption. Credit constraints constitute an attractive alternative hypothesis. Given the uncertainty about income and wealth developments of borrowers, banks typically impose collateral constraints. This paper therefore explores the consequences for fiscal policy of this credit market friction.

7. 7 Figure 1: Euro area: Credit standards applied to the approval of loans to households (net percentages of banks reporting tightening credit standards)

8. 8 Figure 2: US: Credit standards applied to the approval of loans to households (net percentages of banks reporting tightening credit standards)

9. 9 Determinants size fiscal multipliers 1.Degree credit constraints (higher mpc) 2.Monetary policy accommodation ( if Δ i = 0 => r < 0 ) 3.Composition (spending > revenue) 4.Duration (temporary > permanent) Current financial crisis: Increase credit-constrained households Monetary policy more likely to be accommodative  Higher fiscal multipliers

10. 10 QUEST III housing model Extension of the QUEST III model with a housing sector and credit-constrained consumers along the lines of the financial accelerator literature. (Kiyotaki and Moore (1997), Iacoviello (2005), Iacoviello and Neri (2008), Monacelli (2007), Calza, Monacelli and Stracca (2007)) Disaggregation of the household sector into borrowers and lenders. Credit-constrained households: intertemporal optimising over consumption, leisure, housing subject to borrowing constraint (collateral constraint – endogenously linked to nominal value of asset (housing)  Positive co-movement consumption and residential investment

11. 11 Households Ricardian/lenders: intertemporal optimising (utility separable in consumption, leisure and housing services) Full access to financial markets Credit-constrained / borrowers: optimising utility Borrow from Ricardian households Face collateral constraint on borrowing Liquidity-constrained (hand-to-mouth): Consume their current disposable income

12. Households 1: Ricardian households - lenders Period utility function separable in C, leisure and housing services H Ricardian hh hold government bonds and bonds issued by domestic and foreign hh, real capital of T and NT sector

13. Households 2: Credit-constrained households - borrowers Intertemporally optimising (as Ricardians) (i.e. not hand-to- mouth) but: 1.higher rate of time preference β c <β r and 2.they face a collateral constraint on their borrowing : They borrow B c from domestic Ricardian households

14. Housing investment: Shadow price of housing capital ς t = PDV of ratio of the marginal utility of housing services H and consumption C CC: Note: Lagrange multiplier of the collateral constraint ψ - acts like premium on interest rate (fluctuates positively with tightness of constraint) Ric: Consumption: Ric: CC:

15. 15 Households 3: Liquidity-constrained households “Hand-to-mouth”: Consume entire disposable income (no intertemporal optimisation) Wage setting Trade union maximises a joint utility function (distributed equally – population weigths s i ) Wage rule : Wage mark up:

16. 16 Liquidity constrained households do not own financial assets: Credit constrained households only engage in debt contracts with Ricardian households: Aggregation:

17. 17

18. 18 Figure 3: Response of consumption to changes in current income (absolute deviations)

19. 19 Figure 4: Response of consumption to changes in interest rates (% deviations)

20. 20 Credit-constrained hh.: Implications for fiscal policy: Introduction of credit-constraints raises marginal propensity to consume out of current income Credit-constrained households react stronger to fall in real interest rates (raises multiplier when monetary policy is accommodative)

21. 21 Fiscal policy GBC: Tax rule:

22. 22

23. 23 Impulse responses to gov. spending and tax shocks Models: Household shares: RIC_ ────── CC_ - - - - - - - Ricardian households (NLC)0.60.3 Credit constrained hh (CC)-0.3 Liquidity constrained hh (LC)0.4 Two region version of model: EU and RoW Standardised fiscal shocks: 1% of GDP (1 year ) Global shocks

24. 24 Figure 1Temporary increase government consumption: RIC_ : without credit-constrained hh ───── CC_ : with credit-constrained hh - - - - - -

25. 25 Figure 1Temporary increase government consumption: RIC_ : without credit-constrained hh ───── CC_ : with credit-constrained hh - - - - - -

26. 26 Figure 1b Temp. increase gov. cons. + mon. accommodation: RIC_ : without credit-constrained hh ───── CC_ : with credit-constrained hh - - - - - -

27. 27 Figure 1b Temp. increase gov. cons. + mon. accommodation: RIC_ : without credit-constrained hh ───── CC_ : with credit-constrained hh - - - - -

28. 28 Figure 2Temporary reduction labour taxes (1): RIC_ : without credit-constrained hh ───── CC_ : with credit-constrained hh - - - - - -

29. 29 Figure 2Temporary reduction labour taxes (1): RIC_ : without credit-constrained hh ───── CC_ : with credit-constrained hh - - - - - -

30. 30 Figure 2b Temp. reduction lab. Taxes + mon. accommodation: RIC_ : without credit-constrained hh ───── CC_ : with credit-constrained hh - - - - - -

31. 31 Figure 2b Temp. reduction lab. Taxes + mon. accommodation: RIC_ : without credit-constrained hh ───── CC_ : with credit-constrained hh - - - - - -

32. 32 Fiscal multipliers in model with credit-constraints Table 1First year GDP effects of fiscal shocks of 1% of GDP

33. 33 Spill-overs Table 2First year GDP effects of fiscal shocks:

34. 34 Fiscal Policy in the current crisis Temporary fiscal policy measures can be effective to support growth in the current crisis due to increase in credit constraints and monetary policy more likely to be accommodative Global expansion leads to positive spillovers (coordination needed to avoid countries taking a free ride) Design (composition) matters. Need for credible temporary policies (guarantees that expansion does not become permanent): avoid adverse financial market reaction

35. 35

36. 36 Credibility of temporary fiscal expansions: Effects of permanent changes in spending and taxes are much smaller, and generally become negative in the long run (agents anticipate future increases in taxes and reduce their consumption and save more)  Smaller multipliers if stimulus is not perceived as temporary but permanent. Risk premia: unsustainable fiscal strategies may give rise to increase in risk premia (sovereign bonds, (corporate bonds))  Smaller multipliers if stimulus leads to higher borrowing costs for government (and private sector)  Need credible medium-term strategies to deal with increase in debt

37. 37 Figure 4 Credibly temporary vs. permanent shocks : increase government consumption and increase in risk premia Temp.+mon.acc: 1 year increase gov. cons (1% of GDP) with nominal interest rates unchanged Temp.: 1 year increase government consumption (1% of GDP) Perm. : permanent increase gov. consumption (financed by tax increases) Perm.+sov.rp: permanent increase plus sovereign bond risk premium 100 bp. Perm.+rp: permanent increase plus sov. bond risk premium 100bp plus risk premium 25bp

38. Higher fiscal multipliers in financial crisis: Effect of credit-constraints and monetary policy Gov.cons.Labour tax ______ : 40% credit-constrained _ _ _ _ : 60% credit-constrained _._._._ : 60% credit-constrained plus monetary accommodation