Fiscal Multipliers and Balance Sheet Effects in a Small Open Economy/Multiplicadores fiscales y efectos de hoja de balance en una economia pequena y abierta/Multiplicadores fiscais e efeitos do balanco em uma economia pequena e aberta.

• Author: Pineros, Martha Lopez
• Position: Texto en ingles
• Pages: NA

Introduction

Advanced and emerging economies during 2007-2009 were affected by the worst financial crises since the Great Depression. As a response to the crises, governments have implemented different fiscal stimulus packages. One question arising from the fiscal policy implemented is how big the fiscal multipliers could be in a world with financial frictions. Some models, developed by Freedman et al. (2010), Fernandez-Villaverde (2010), and Carrillo and Poilly (2013), among others, have focused their attention in advanced economies, closed economies, and the recent financial crises. In their closed economy models (CEM) for the United States, these authors have found that financial frictions combined with a Fisher effect cause the increases in investment due to balance sheet effects with the result of high fiscal multipliers.

We focus our attention in Colombia, a small open economy, because it is an emerging country that, during the late nineties, suffered a strong recession, due to significant balance sheet effects reinforced by the fact that the monetary authority tried to maintain the real exchange rate fixed. The shock originated in the Asian crises, and it also affected several other small open economies, which was the moment of a country risk premium increment that emerging economies had to pay, with the foreign-interest rate, for their foreign debt. More recently, like in many other small open economies, the country faced capital outflows that had important effects. The way to deal with the crises was, in part, by increasing government expenditure. How big is the output and investment's fiscal multiplier in the context of economies that experience strong movements in the real exchange rates and capital inflows and outflows that are foreign interest rates takers, which call for a detailed study?

The goal of the paper is two-fold. First, we present empirical evidence for a small open economy, Colombia, on how big is the fiscal multiplier of output and investment? Second, we set up a DSGE model for a small open economy (SOEM) that asses the question if the findings regarding investment by Fernandez-Villaverde (2010) (FV from now on), and Carrillo and Poilly (2013) (CP for now on) still hold. More specifically, we want to analyze what is the role of the real exchange rate on a model with financial frictions and nominal contracts. What happens to investment in the case of a small open economy in the context of our model? What are the results depending on the degree of the country risk premium that faces the economy? Finally, as long as one feature of a SOE is to be populated by non-Ricardian consumers, we analyze which is its interaction with the real exchange rate and their impact on the fiscal multipliers.

For these purposes, we present empirical evidence based mainly in Ramey's (2011) methodology for the identification of the government spending shock. Second, we develop a fiscal DSGE model with balance sheet effects a la Bernanke, Gertler, and Gilchrist (1999) for a small open economy, characterized by the presence of non-Ricardian agents and nominal contracts. The model replicates the empirical evidence of an investment increment.

The model consists of 7 sectors. The household sector is divided into Ricardian and non-Ricardian agents. The entrepreneurial sector, which makes the investment decisions and faces a costly state verification problem giving rise to an external finance premium that depends on the balance sheet of the firm and, because contracts are nominal, it also depends on inflation. The third sector is the capital producers' sector, which purchases consumption goods as material input, combines it with rented capital, and produces new capital. The fourth is the retailers' sector that uses the wholesale output of entrepreneurs, differentiates it, and sets prices a la Calvo (1983). We also model a national agency in the labor market. There is also a description of the rest of the world's sector. Finally, we have the government, which conducts monetary and fiscal policies. Fiscal policy is characterized by a public sector that collects income taxes and receipts revenues from oil production. Accordingly, this last sector follows a structural fiscal rule.

Our results are as follows. With respect to the empirical investigation, we found that the investment multiplier is positive, which means that there is not investment crowding out: is about 1% in impact and close to 2% in the fifth quarter. The fiscal consumption multiplier is also positive and close to the output fiscal multiplier of 1.2% in the third quarter.

From the model's perspective, we first contrasted a model without the Fisher effect (no nominal contracts) with one with the Fisher effect. We analyzed the role of nominal contracts in the economy and found that if there is no Fisher effect, investment falls due to increases in real interest rates that cause a fall in the price of capital and net worth, and an increase in the external finance premium of the entrepreneurs. On the contrary, as in FV and CP, nominal contracts cause a lower external finance premium, an increase in investment, and higher output multipliers. Moreover, in the case of the model with the Fisher effect, the real exchange rate appreciates more due to the higher fiscal multipliers. In this case, the real interest rates are lower, which translates into a higher price of capital that causes an improvement in the external finance premium that, in turn, causes even higher increments in investment.

Then, we analyzed the case of a SOEM VS CEM--here a closed economy model refers to one were the imports share is lower in the consumers bundle than in a SOEM--. In this case, for the SOEM, there is an import-substitution effect that affects the total inflation rate causing higher interest rates and lower price of capital, which, in turn, causes lower investment than in the CEM, which in small open economies the fiscal multipliers of investment and output are lower than in closed economies. Here, the higher fiscal multipliers in the CEM cause higher real exchange rate appreciation reinforcing the balance sheet effects. With respect to the country risk premium, our findings show that the lower the country risk premium, the higher the fiscal multiplier of investment and output.

Finally, regarding the interaction between the presence of non-Ricardian agents and balance sheet effects, our results show that in the same way that in Gali, Lopez-Salido, and Valles (2007), and Monacelli and Perotti (2010), the fiscal multipliers are higher in the case of non-Ricardian consumers because of the increase in consumption of this agents. However, the increase in investment is not very different among the two models, and neither is the behavior of the real exchange rate or the balance sheets effects.

The remainder of this paper proceeds as follows: Section 1 presents the related literature. Section 2 presents the empirical evidence for the Colombian economy. Section 3 presents the model. Section 4 the calibration of the model. Section 5 discusses the results, and section 6 presents the conclusions.

1. Related Literature

   Our results contribute to several strands of literature. First of all, they examine the effect of government spending on consumption and output; for example, Colciago (2011), Gali et al. (2007), and Monacelli and Perotti (2010), who intended to replicate the effect of government spending on consumption for advanced economies. However, as these papers do not include balance sheet effects, they tend to underestimate the impact of the fiscal multiplier, as we will show here. Our results also add to the literature that examines the output and fiscal consumption multipliers, using a DSGE model enriched with financial frictions (Sin, 2016; Castro et al., 2014). These papers are also meant to replicate stylized facts for small open economies. But they do not model the role of non-Ricardian agents in these kinds of economies and, therefore, their fiscal consumption multipliers tend to be very small, as we will show later in our study.

   Our paper also relates to the strand of literature that studies fiscal stimulus and crowding out effects on investment under the presence of financial frictions (see, Freedman et al. (2010), Carrillo and Poilly (2013), and Fernandez-Villaverde (2010) for advanced economies). The first two focus on the fiscal stimulus during the recent financial recession of the United States, while the latter introduced the debt-deflation Fisher effect for nominal contracts in a CEM for the United States. In this regard, our contributions first analyzed the crowding out of the effect of the government spending on investment under the presence of financial frictions for small open economies and, second, examined the prediction of increases in investment in the case of nominal contracts but for the case of small open economies.

   Another related literature deals with the Dutch disease phenomenon that affected several countries around the world during 2003-2013 due to the increase in commodity prices (Garcia-Cicco & Kawamura, 2015; Fernandez & Villar, 2014; Goda & Torres, 2015; Pieschacon, 2012; Sarmiento & Lopez, 2016). One way to deal with this phenomenon has been the implementation of fiscal rules, and our theoretical model includes this characteristic in the Colombian economy.

2. Empirical Evidence

   The empirical evidence about the effect of a fiscal expenditure shock on consumption and investment is escarse. Here, we add to the fiscal multipliers' empirical literature that has found that consumption increases after a fiscal expenditure shock, and we present evidence on what happens to investment.

   Following Vargas, Gonzalez, and Lozano (2012), we identified the government spending shock with a method that meets the criteria of non-anticipation and no-contemporaneous correlation with output. To do so, we defined the shock as the difference between the Central...