How Loose, How Tight? A Measure of Monetary and Fiscal Stance for the Euro Area

WP/20/86 How Loose, How Tight? A Measure of Monetary and Fiscal Stance for the Euro Area by Nicoletta Batini, Alessandro Cantelmo, Giovanni Melina and Stefania Villa IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. © 2020 International Monetary Fund WP/20/86 IMF Working Paper Research Department How Loose, How Tight? A Measure of Monetary and Fiscal Stance for the Euro Area1 Prepared by Nicoletta Batini, Alessandro Cantelmo, Giovanni Melina and Stefania Villa Authorized for distribution by Chris Papageorgiou May 2020 Abstract This paper builds a model-based dynamic monetary and fiscal conditions index (DMFCI) and uses it to examine the evolution of the joint stance of monetary and fiscal policies in the euro area (EA) and in its three largest member countries over the period 2007-2018. The index is based on the relative impacts of monetary and fiscal policy on demand using actual and simulated data from rich estimated models featuring also financial intermediaries and long-term government debt. The analysis highlights a short-lived fiscal expansion in the aftermath of the Global Financial Crisis, followed by a quick tightening, with monetary policy left to be the “only game in town” after 2013. Individual countries’ DMFCIs show that national policy stances did not always mirror the evolution of the aggregate stance at the EA level, due to heterogeneity in the fiscal stance. JEL Classification Numbers: E4, E5, E6 Keywords: policy stance, euro area, monetary policy, fiscal policy. Author’s E-Mail Address: nbatini@imf.org, alessandro.cantelmo@esterni.bancaditalia.it, gmelina@imf.org, stefania.villa@bancaditalia.it 1 Batini: IMF Independent Evaluation Office; Cantelmo: Fellow at Banca d’Italia; Melina: IMF Research Department; Villa: Banca d’Italia. We are grateful to Fabio Busetti, Jean-Marc Fournier, Andrea Gerali, Roland Meeks, Stefano Neri, Andrea Nobili, Massimiliano Pisani, Pietro Rizza, Andre Santos, Rachel van Elkan and Roberta Zizza for useful comments and suggestions and to Cynthia Wu and Dora Xia for providing the series for the shadow rate in the euro area. All remaining errors are ours. IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, IMF management, or the IMF Independent Evaluation Office, or of Banca d’Italia. Contents1 Introduction62 Model103 Bayesian Estimation134 Dynamic Monetary-Fiscal Condition Indices (DMFCIs)174.1 Relation with the Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . 174.2 Computation of the DMFCI . . . . . . . . . . . . . . . . . . . . . . . . . . . 184.3 Evolution of DMFCIs in the Euro Area . . . . . . . . . . . . . . . . . . . . . 214.4 Comparison with Alternative Available Indices . . . . . . . . . . . . . . . . . 224.5 Comparison between DMFCIs and Historical Contribution of Shocks in theDSGE Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254.6 Dynamic Properties of the DMFCI in the Light of the DSGE Model . . . . . 295 Concluding Remarks31References33AppendixiA Detailed description of the modeliA.1 Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .iA.1.1 Optimizing Households . . . . . . . . . . . . . . . . . . . . . . . . . .iA.1.2 Rule-of-Thumb Households . . . . . . . . . . . . . . . . . . . . . . . . iiiA.1.3 Wage Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ivA.1.4 Aggregation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vA.2 Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vA.3 Non-Financial Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . viiiA.4 New Capital Producers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ixA.5 Trade and Market Clearing . . . . . . . . . . . . . . . . . . . . . . . . . . . . xA.6 Equilibrium and Exogenous Processes . . . . . . . . . . . . . . . . . . . . . . xiB Equilibrium Conditions of the Detrended SystemxiiB.1 Domestic Country . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiiB.2 Foreign Country . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xv3 B.3 Market Clearing and Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . xviiB.4 Central Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xviiiB.5 Exogenous Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xviiiC Steady StatexixD Detailed Derivation of the Wage Setting Equati