Effects of the supply-side channel on stabilisation properties of policy rules

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BANK OF FINLAND

DISCUSSION PAPERS

34 · 2003

Jukka Railavo

Research Department

8.12.2003

Effects of the supply-side

channel on stabilisation

properties of policy rules

Suomen Pankin keskustelualoitteita Finlands Banks diskussionsunderlag

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Suomen Pankki Bank of Finland P.O.Box 160 FIN-00101 HELSINKI Finland ( (( ( + 358 9 1831

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BANK OF FINLAND

DISCUSSION PAPERS

34 · 2003

Jukka Railavo*

Research Department

8.12.2003

Effects of the supply-side channel on

stabilisation properties of policy rules

The views expressed are those of the author and do not necessarily reflect the views of the Bank of Finland.

I am grateful to Juha Tarkka and Jouko Vilmunen for encouraging and helpful comments. Also the comments from Martin Ellison, Seppo Honkapohja, Jarmo Kontulainen, Tuomas Takalo, Matti Virén and the participants of the Bank of Finland workshop on modelling of monetary policy are gratefully acknowledged. I would also like to thank the participants of the ZEI Summer School 2003 for useful comments.

* Bank of Finland, P.O. Box 160, FIN-00101 Helsinki, Finland. Tel. +358-9-183 2932. E-mail: [email protected]

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http://www.bof.fi ISBN 952-462-108-8 ISSN 0785-3572 (print) ISBN 952-462-109-6 ISSN 1456-6184 (online)

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Effects of the supply-side channel on stabilisation

properties of policy rules

Bank of Finland Discussion Papers 34/2003

Jukka Railavo

Research Department

Abstract

In this paper we introduce an application of the supply-side channel for fiscal policy to the basic New Keynesian model. We use a proportional tax rate instead of lump sum tax and introduce the distortions of a tax wedge. We derive a closed economy forward-looking model with government consumption and no capital. Households’ labour supply decisions are endogenised. Monetary policy is conducted by a Taylor-type interest rate rule and fiscal policy follows a simple debt rule. We analyse the stability of the model when fiscal policy has both demand and supply-side effects and compare results with the standard case of only demand effects. We show that taking supply-side effects into account restricts the fiscal policy parameter range consistent with the dynamic stability of the economy. We also argue that allowing fiscal policy to affect both supply and demand results in more persistent inflation as well as output responses to shocks, than without the supply-side channel. We also discuss the different monetary and fiscal policy regimes and their implication on the stability of inflation and output. Key words: inflation, fiscal and monetary policy, stabilisation

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Tarjontakanavan vaikutukset talouspolitiikan

sääntöjen vakausominaisuuksiin

Suomen Pankin keskustelualoitteita 34/2003

Jukka Railavo Tutkimusosasto

Tiivistelmä

Tässä tutkimuksessa arvioidaan finanssipolitiikan tarjontakanavan vaikutuksia uuskeynesiläisessä mallissa. Tutkimuksessa on käytetty suhteellista verotusta kiinteän könttäsummaveron sijasta, mikä tuo tarjontaan verokiilan aiheuttamia vääristymiä. Tutkimuksessa johdetaan eteenpäin katsova suljetun talouden malli, jossa ei oteta huomioon pääomaa, mutta joka sisältää julkisen sektorin. Kotitalous voi päättää itse työntarjonnasta. Rahapolitiikkaa hoidetaan Taylorin säännön avul-la, ja finanssipolitiikka seuraa yksinkertaista velkasääntöä. Tutkimuksessa analy-soidaan mallin vakautta, kun finanssipolitiikalla on sekä kysyntä- että tarjontavai-kutuksia. Työssä osoitetaan, että tarjontavaikutusten huomioon ottaminen rajoittaa finanssipolitiikan parametrien vaihteluväliä, joka on sopusoinnussa talouden dy-naamisen tasapainon kanssa. Tutkimuksessa väitetään, että kun finanssipolitiikan sallitaan vaikuttaa myös tarjontaan kysynnän lisäksi, on sokkien seurauksena py-syvämpiä inflaatio- ja tuotantovaikutuksia kuin ilman tarjontakanavaa. Lisäksi tut-kimuksessa vertaillaan eri raha- ja finanssipolitiikan yhdistelmiä ja niiden vaiku-tusta inflaation ja tuotannon vakauteen.

Avainsanat: inflaatio, finanssi- ja rahapolitiikka, vakaus JEL-luokittelu: E52, E31, E63

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(29)

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Effects of the supply-side channel on stabilisation properties of policy rules

BANK OF FINLAND

Jukka Railavo*

Effects of the supply-side channel on stabilisation

Tarjontakanavan vaikutukset talouspolitiikan

Contents

3 Stabilising properties of the model ...17

4 Lqwurgxfwlrq

5 Wkh prgho

515 Wkh up

516 Wkh jryhuqphqw

517 Srolf| uxohv

6 Vwdelolvlqj surshuwlhv ri wkh prgho

615 Ghew uxoh zlwk vxsso|0vlgh hhfwv

616 Ghew uxoh zlwk h{rjhqrxv srwhqwldo rxwsxw

617 Vlpxodwlrq

7 Frqfoxvlrqv

Uhihuhqfhv

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