Ten Years Later: Lessons for DSGE Builders and Czech Policy Makers

Issue: 3/2019

Aleš Michl

Faculty of Finance and Accounting, University of Economics, Prague, Czech Republic, ales.michl@gmail.com.

We show an example of a small open economy – the Czech Republic – where the fiscal restriction was put in place between 2010 and 2013 in a negative output gap and zero lower bound on nominal interest rates. According to our results, such fiscal policy seems to have been mistaken, as the restriction may apparently have caused a second recession in the Czech Republic in 2012/2013 (after the global recession in 2008/2009). Instead of the dynamic stochastic general equilibrium approach (DSGE), we applied a tractable static deterministic partial equilibrium approach using the IS-LM framework. We derived mathematically from the IS-LM model that expansionary fiscal policy acting via higher government investment can be an appropriate tool for reacting to a crisis in the very short run when interest rates hit the zero lower bound. Expansionary fiscal policy after the 2008/2009 crisis would probably have led to faster stabilisation of the Czech economy. We simulate a potential increase in government investment of 8% yearly between 2011 and 2013. This would have added 0.4 pp to GDP growth and increased the inflation rate by about 0.5 pp. Hence, the inflation outlook in 2013 would not have been negative and would consequently have led to less pressure for monetary policy expansion using unconventional interventions against the Czech koruna.

DOI: 10.2478/revecp-2019-0009
JEL: E12, E41, E44, E62
Keywords: IS-LM model, DSGE, zero lower bound, Fiscal Policy, monetary policy

ALESINA, A., FAVERO, C., GIAVAZZI, F. (2019). Austerity: When It Works and When It Doesn’t. Princeton; Oxford: Princeton University Press.

ALIYEV, I., BOBKOVÁ, B., ŠTORK, Z. (2014). Extended DSGE Model of the Czech Economy. Ministry of Finance, Czech Republic, No. 1/2014.

AMBRIŠKO, R., AUGUSTA, V., HÁJKOVÁ, D., KRÁL, P., NETUŠILOVÁ, P., ŘÍKOVSKÝ, M., SOUKUP, P. (2012). Fiscal Discretion in the Czech Republic in 2001–2011: Has It Been Stabilizing? CNB Research and Policy Note 1/2012.

ANDRLE, M., HLÉDIK, T., KAMENÍK, O., VLČEK, J. (2009). Implementing the New Structural Model of the Czech National Bank. CNB Working Paper 2/2009.

BENEŠ, J., HLÉDIK, T., KUMHOF, M., VÁVRA, D. (2005). An Economy in Transition and DSGE: What the Czech National Bank’s New Projection Model Needs. CNB Working Paper 12/2005.

BERNANKE, B., GERTLER, M., GILCHRIST, S. (1998). The Financial Accelerator in a Quantitative Business Cycle Framework. Working Paper 6455, National Bureau of Economic Research.

BLANCHARD, O. (2018). On the Future of Macroeconomic Models. Oxford Review of Economic Policy, 34(1-2), 43-54. DOI: 10.1093/oxrep/grx045

BOX, G. E. P. (1976). Science and Statistics. Journal of the American Statistical Association, 71, 791-799. DOI: 10.1080/01621459.1976.10480949

BRŮHA, J. (2015). Dynamics of Linear Forward-looking Structural Macroeconomic Models at the Zero Lower Bound: Do Solution Techniques Matter?, CNB WP 13/2015.

BRŮHA, J., HLÉDIK, T. (2018). Mají DSGE modely budoucnost? – zamyšlení nad textem Oliviera Blancharda. Czech National Bank, internal report, mimeo.

BRŮHA, J., TONNER, J. (2017). An Exchange Rate Floor as an Instrument of Monetary Policy: An Ex-post Assessment of the Czech Experience, Czech National Bank, CNB Working Paper Series 4/2017.

BURDA, M., WYPLOSZ, C. (2013). Macroeconomics: A European Text. 6th Edition, Oxford University Press.

CAMPBELL, J., MANKIW, G. (1989). Consumption, Income and Interest Rates: Reinterpreting the Time Series Evidence. NBER Chapters, in: NBER Macroeconomics Annual 1989, Volume 4, 185-246. National Bureau of Economic Research, Inc.

CARTER, M. (2001). Foundations of Mathematical Economics. MIT Press Books, The MIT Press, edition 1, volume 1, number 0262032899, January.

CHRISTIANO, L., MOTTO, R., ROSTANGO, M. (2014). Risk Shocks. American Economic Review, 104(1), 27-65. DOI: 10.1257/aer.104.1.27

COLANDER, D. (2003). The Strange Persistence of the IS/LM Model. Paper prepared for the HOPE conference on The IS/LM Model: Its Rise, Fall and Strange Persistence. Duke University. April 25–27, 2003.

DEGRAUWE, P., GROSS, D. (2009). A New Two-Pillar Strategy for the ECB. CESifo Working Paper Series 2818, CESifo Group Munich.

FRANTA, M.,  HOLUB, T., KRÁL, P. KUBICOVÁ, I., ŠMÍDKOVÁ, K., VAŠÍČEK, B. (2014). The Exchange Rate as an Instrument at Zero Interest Rates: The Case of the Czech Republic. CNB Research and Policy Notes 2014/03.

GALÍ, J., LOPEZ-SALIDO, J., VALLES, J. (2007). Understanding the Effects of Government Spending on Consumption. Journal of the European Economic Association, 13(6), 227-270. DOI: 10.1162/JEEA.2007.5.1.227

HANSEN, A. H. (1949). Monetary Theory and Fiscal Policy. 1st Edition. New York: McGraw-Hill.

HICKS, J. R. (1937). Mr. Keynes and the “Classics”; A Suggested Interpretation. Econometrica, 5(2), 147-159. DOI: 10.2307/1907242

HICKS, J. R. (1976). Some Questions of Time in Economics. In Evolution, Welfare and Time in Economics.139-154.

HICKS, J. R. (1980). IS-LM: An Explanation. Journal of Post Keynesian Economics, 3(2), DOI: 10.1080/01603477.1980.11489209

IMF, MIT. (2014). Post-Crisis Fiscal Policy. Cambridge, Massachusetts: Massachusetts Institute of Technology and the International Monetary Fund. ISBN 978-0-262-02718-2.

Justiniano, A., Primiceri, G., Tambalotti, A. (2017). Empirical DSGE Models: From the Great Moderation to the Great Recession and Beyond. In DSGE Models in the Conduct of Policy: Use as Intended, edited by Refet Gürkaynak and Cédric Tille, a VoxEU.org Book, CEPR Press, April 2017.

KENNEDY, M. (2011). Background Notes on Fiscal Policy. Queen’s University.

KILEY, M. T., ROBERTS, J. M. (2017). Monetary Policy in a Low Interest Rate World. Brookings Papers on Economic Activity, BPEA Conference Drafts, March 23–24, 2017.

KOENIG, E. (2011). An IS-LM Analysis of the Zero-Bound Problem. Federal Reserve Bank of Minneapolis. Staff Papers nb. 13.

KRUGMAN, P. (2011). IS-LMentary. The New York Times, October 9, 2011.

KRUGMAN, P. (2018). Good Enough for Government Work? Macroeconomics since the Crisis. Oxford Review of Economic Policy, 34(1-2), 156-168.

MADIGAN, B., MEYER, S., REIFSCHNEIDER, D. (2008). Notes on Issues Related to the Zero Lower Bound on Nominal Interest Rates. Federal Open Market Committee.

MCCALLUM, B. T. (2000). Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates. Journal of Money, Credit and Banking, 32(4), 870-904. DOI: 10.2307/2601148

MERTENS, T., WILLIAMS, J. (2019). Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates. Federal Reserve Bank of New York Staff Reports 877.

Oxford Review of Economic Policy (2018), Volume 34, Issue 1-2, Spring-Summer 2018. Rebuilding macroeconomic theory. https://academic.oup.com/oxrep/issue/34/1-2

PARKER, J., SOULELES, N., JOHNSON, D., MCCELLAND, R. (2013). Consumer Spending and the Economic Stimulus Payments of 2008. American Economic Review, 103(6). 2530-2553. ISSN: 0002-8282.DOI: 10.1257/aer.103.6.2530

RACHEL, L., SUMMERS, L. (2019). On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation. Brookings Papers on Economic Activity, forthcoming.

ROBERTSON, D. H. (1936). Some Notes on Mr. Keynes’ General Theory of Interest. Quarterly Journal of Economics, 51, 168–191. DOI: 10.2307/1882506

ROMER, D. (2000). Keynesian Macroeconomics without the LM Curve. Journal of Economic Perspectives, 14(2), 149–169. DOI: 10.1257/jep.14.2.149

Ryšánek, J., Tonner, J., Tvrz, S., Vašíček, O. (2012). Monetary Policy Implications of Financial Frictions in the Czech Republic. CNB Working Paper 12/2011.

TOBIN, J. (1981). Money and Finance in the Macro-Economic Process. James Tobin – Prize Lecture. NobelPrize.org. Nobel Media AB 2018. Sun 7 Oct 2018.

WILLIAMS, J. (2018). DSGE Models: A Cup Half Full. VoxEU, 8 Apr 2018.