1. Investment Planning Costs and the effects of Fiscal and Monetary Policy Susanto Basu and Miles S. Kimball Frontiers of Macroeconomics Conference, June 5-6, 2006, UQAM

2. Frontiers of Macro, June 20062 Motivation Search for a model that can explain effect of monetary, fiscal and technology shocks Sticky prices needed to explain monetary shocks “Old Keynesian” literature: With sticky prices and investment, increased G has no effect on Y We examine in New Keynesian model Confirm puzzle; suggest a solution

3. Frontiers of Macro, June 20063 Tobin (1955): The first DGE model of cycles? A “Solow” model Exogenously fixed nominal wage Result: Increase in G crowds out I one-for-one Has no effect on Y

4. Frontiers of Macro, June 20064 Modern literature adds a lot Consumer optimization Natural rate property Rational expectations Sticky prices instead of wages We show: The upshot is now that Y falls if G rises

5. Frontiers of Macro, June 20065 A new puzzle Standard RBC/NK models predict that C should fall if G rises (a negative wealth shock) Contrary to evidence in Blanchard-Perotti (2002) Gali et al. (2006) confirm the puzzle Their solution: Add rule of thumb (RoT) consumers Motivated by Campbell-Mankiw (1989) Do we need Old Keynesian consumption function to solve a New Keynesian puzzle?

6. Frontiers of Macro, June 20066 Building blocks of the model Consumer with King-Plosser-Rebelo (1988) prefs Calvo pricing Capital accumulation LM curve (exogenous money) G shocks financed with lump-sum taxes Baseline model: No investment frictions Extended model: Investment (higher-order) adjustment costs, similar to CEE

7. Frontiers of Macro, June 20067 Why are “good” real shocks contractionary in the baseline model? Cobb-Douglas production: First-order condition: where  is the ex post markup

8. Frontiers of Macro, June 20068 “Expansionary” real shocks raise  Price level a state variable MC(Y,.) jumps down in response to “good” shocks e.g., technology improvement, lower labor taxes, or fiscal expansion (lowers wages) Thus, markup rises Anticipate that  will fall back to  * as prices adjust Firms delay investment to avoid capital losses Collapse in investment demand lowers output

9. Frontiers of Macro, June 20069 KE-LM diagram r Y KE’ KE LM

10. Frontiers of Macro, June 200610 Monetary policy Clear from diagram that prediction depends on monetary policy rule Our rule is that the authority holds M fixed Different policy rules might have different implications But the basic lesson is still that “good” real shocks will lower output, unless the central bank takes action Fiscal expansion is not an independent stimulus in the baseline model

11. Frontiers of Macro, June 200611 Baseline model results

12. Frontiers of Macro, June 200612 Baseline model results, cont’d

13. Frontiers of Macro, June 200613 Flex-price version has similar problems

14. Frontiers of Macro, June 200614 Ideas for a fix If collapse of investment leads to output decline, what if investment is hard to change? Paper argues that higher-order adjustment costs are also the key to hump-shaped IRFs from money, and necessary for the liquidity effect What else is necessary to get a positive consumption response to a negative wealth shock?

15. Frontiers of Macro, June 200615 Implications of KPR utility

16. Frontiers of Macro, June 200616 Will KPR + higher-order costs fix? Suppose  is small, as in most estimates Use 0.20, from estimating KPR model with aggregate U.S. data (Basu-Kimball, 2002) Then a shock that requires higher N will tend to pull up C as well Suppose I is a state variable Since Y = C + I + G, equilibrium with low  might call for higher Y, N, and C in response to increased G

17. Frontiers of Macro, June 200617 Sticky-investment model with low IES

18. Frontiers of Macro, June 200618 Sticky-investment model with low IES, cont’d

19. Frontiers of Macro, June 200619 Need for cyclical markups (e.g., sticky prices)

20. Frontiers of Macro, June 200620 Why KPR and not RoT? Campbell-Mankiw (1989) essentially run this equation with  y instead of  n Two variables are strongly positively correlated Regressing  c on r,  n and  y, find that  y is never significant (Basu-Kimball, 2002) Micro evidence leaves no doubt that PIH is violated by some people, some times But are those violations big enough for us to assume 50% of disposable income goes to people who just spend what they get?

21. Frontiers of Macro, June 200621 Conclusion Need to use responses to multiple shocks to refine a single model of business cycles Basic model can’t change with the type of shock Sticky prices + real shocks = unexpected results For policy purposes, need to understand what would happen without monetary intervention KPR and sticky investment (useful on other grounds) can explain fiscal shock/consumption puzzle Neither KPR nor RoT approach does a good job of explaining the extreme persistence of the positive C response (estimated at 20+ quarters by Gali et al.)