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Board of Governors of the Federal Reserve SystemInternational Finance Discussion PapersNumber 825, January 2005--- Screen ReaderVersion*

# Expansionary Fiscal Shocks and the Trade Deficit*

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Abstract:

In this paper, we use an open economy DGE model (SIGMA) toassess the quantitative effects of fiscal shocks on the tradebalance in the United States. We examine the effects of twoalternative fiscal shocks: a rise in government consumption, and areduction in the labor income tax rate. Our salient finding is thata fiscal deficit has a relatively small effect on the U.S. tradebalance, irrespective of whether the source is a spending increaseor tax cut. In our benchmark calibration, we find that a rise inthe fiscal deficit of one percentage point of GDP induces the tradebalance to deteriorate by less than 0.2 percentage point of GDP.Noticeably larger effects are only likely to be elicited underimplausibly high values of the short-run trade priceelasticity.

Keywords: DGE model, open-economy macroeconomics.

JEL classification: F32, F41, E62.

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# 1  Introduction

After a decade of relative inattention, there is renewedinterest in assessing the relationship between fiscal policy andtrade deficits. This interest has been fuelled by the steadyincrease in the U.S. trade deficit to over 5 percent of GDP inearly 2004, and the more recent swing in the U.S. fiscal balancefrom surplus to a large deficit (see Figure 1).

Some economists and policymakers believe that fiscal deficitshave played a fairly minor role in accounting for the increase inthe trade deficit, and instead have attributed the U.S. tradebalance deterioration to other factors. A proponent of this view isU.S. Treasury Undersecretary John Taylor (2004):
> 
*The increase of the U.S. current account deficitover more than a decade has been linked to domestic U.S. capitalformation increasing more than U.S. saving. Perceived high rates ofreturn on U.S. assets, based on strong productivity growth relativeto the rest of the world, combined with an efficient and secureU.S. capital market attracts foreign investment.*

By contrast, others have argued that fiscal deficits play acentral role in explaining both the persistence and recentexpansion of the trade deficit. For example, Bradford DeLong (2004)has observed that:
> 
*We have a large trade deficit now - and did not backin 1997, [...] because (a) the federal government budget deficit ismuch larger now than it was then, and (b) private savings declinedas a share of GDP during the bubble years of the late 1990s, andhas not fully recovered.*

It does not seem feasible to discriminate between thesealternative views based on a simple examination of the jointevolution of the fiscal and trade balances. As seen in Figure 1,the fiscal deficits of the 1980s and early part of this decade wereindeed associated with a pronounced deterioration of the tradebalance. However, the fiscal and trade balances frequently havemoved in opposite directions, perhaps reflecting an endogenouscomponent of the fiscal balance, and that other factors have playeda significant role in driving the trade balance. Thus, methods moresophisticated than "eyeball econometrics" are required to isolatethe effects of fiscal policy changes on the trade balance.

In this context, it is natural to turn to the empiricalliterature to help assess the linkage between fiscal policy and thetrade deficit. Unfortunately, the literature appears to offerwidely divergent estimates, and there is even disagreement aboutthe sign of the effect of a fiscal deficit on the trade balance.For example, Roubini (1988) and Normandin (1999) found thatgovernment budget deficits induced a fairly substantialdeterioration in the trade deficit, with the latter estimating thata one dollar increase in the fiscal deficit of the United Statesresulted in an increase in the external deficit between $0.22 and$0.98. By contrast, Evans (1988) and Bussière et al (2004)concluded that the fiscal deficits only have a small effect on thecurrent account, and Roubini and Kim (2003) reported the surprisingfinding based on structural VAR analysis that expansionary fiscalshocks tend to improve the current account.

In this paper, we take an alternative approach by using an openeconomy DGE model to assess the quantitative effect of fiscalshocks on the trade balance. Our model is a slightly modifiedversion of a new micro-founded multi-country model named "SIGMA"that we have developed in the International Finance Division of theFederal Reserve Board.1 Our model builds on the framework ofthe workhorse new Keynesian model by incorporating many of the keynominal and real frictions that have been identified in the recentliterature as playing an important role in accounting for theeffects of both real and monetary shocks. Our model also introducesheterogeneity across households by assuming that some householdssimply consume their after-tax disposable income each period; suchnon-Ricardian behavior has important implications for fiscalpolicy.

We examine the effects of two alternative fiscal shocks,including a rise in government consumption, and a reduction in thelabor income tax rate. As shown in Figure 2, both higher governmentspending and tax reductions have contributed to the large swing inthe fiscal balance from surplus to substantial deficit during thepast few years.

Our salient finding is that fiscal shocks have relatively smalleffects on the trade balance under reasonable calibrations of ourmodel to the U.S. economy. In our benchmark calibration, we findthat a one percentage point rise in the government spending shareof GDP induces the trade balance/GDP ratio to deteriorate by lessthan 0.2 percentage point after 2-3 years (where the effect reachesa maximum). The small effect reflects that the pressure on theexternal sector associated with higher fiscal spending is largelyalleviated through a rise in output, and by a contraction inprivate domestic absorption due to higher real interest rates and anegative wealth effect. Moreover, a labor tax rate cut that isscaled to induce a deterioration of the fiscal balance of about 1percentage point of GDP (about the same as the government spendingshock) also generates a trade balance deterioration of less than0.2 percentage point of GDP.

Our small estimates of the effects of fiscal shocks on trade mayappear surprising. Some previous work using micro-founded openeconomy models reported considerably larger effects; for instance,Baxter (1995) found that a one percentage point rise in thegovernment spending/GDP share caused a trade balance deteriorationequal to about 0.5 percentage point of GDP. We show that theprimary difference between our analysis and this earlier work isthat our baseline calibration implies a much lower short-run priceelasticity of export and import demand. We corroborate that ahigher trade price elasticity indeed makes the trade balance moreresponsive, since a higher elasticity shifts more of the adjustmenttowards net exports; however, we argue that short-run trade priceelasticities would have to be implausibly high to yieldsubstantially larger effects than in our benchmark calibration. Thelong-run price elasticity of 1.5 for exports and imports that weuse in our benchmark calibration may in fact exaggerate the traderesponse, as it is at the upper end of estimates in themacro-literature.

We conduct sensitivity analysis on several other dimensions,including to the interest sensitivity of consumption and investmentspending, the form of the monetary policy rule, the share ofnon-Ricardian households in the economy, and the persistence of theshocks. We find that our estimates of the impact of the fiscalshocks on trade are fairly insensitive to the interest-sensitivityof the demand components, and to the form of the monetary policyrule. Moreover, we argue that our baseline calibration if anythingtends to exaggerate the effects of fiscal shocks on the tradebalance through our assumptions that non-Ricardian agents comprise50 percent of households.

We also confront the question of whether our benchmark modeloffers an empirically realistic framework for assessing the effectsof fiscal policy shocks. While our model's implications for theevolution of output, consumption and investment are qualitativelyconsistent with the structural VAR evidence reported by Blanchardand Perotti (2002), our benchmark model implies significantly morerapid adjustment of output and the expenditure components.Accordingly, we consider an alternative information structure inwhich agents have incomplete information about the persistence ofthe government spending shock. This framework allows our model tocome much closer to matching the highly persistent responses ofoutput and the expenditure components derived from the empiricalVAR analysis, and also from large-scale policy models in whichexpectations are formed adaptively.2 Interestingly, theeffects of a government spending shock on the trade balance underimperfect information are somewhat smaller than in our benchmarkcalibration with full information.

Applying our framework to the current situation, our analysissuggests that while stimulative fiscal policy has probablycontributed to the large and widening U.S. trade deficit, itsquantitative role has been modest. Even assuming that thestructural U.S. government deficit has deteriorated by 5 percentagepoints of GDP due to spending increases and tax cuts - and thusmaking the rather extreme assumption that most of the swing in thefiscal position is due to policy shocks - our estimates wouldsuggest that such stimulus would generate a trade deficit of lessthan 1 percent of GDP. This suggests that most of the U.S. tradedeficit has been driven by factors other than the fiscal expansion,including possibly shifts in portfolio preferences towards U.S.assets, and the continued strength in labor productivitygrowth.

The remainder of this paper is organized as follows. Section 2presents our basic open economy model. The calibration is discussedin Section 3. Section 4 reports our simulation results. Section 5concludes.

# 2  The Model

Our model consists of two countries that differ in size, but areotherwise isomorphic. Hence, our exposition below focuses on the"home" country. Each country in effect produces a single domesticoutput good, although we adopt a standard monopolisticallycompetitive framework to rationalize stickiness in the aggregateprice level. While household utility depends on consumption of boththe domestic output good and imported goods, it is convenient toassume that a competitive distribution sector purchases bothinputs, and simply resells a final consumption good to households.Similarly, we assume that competitive distributors combine thedomestic output good with imports to produce a final investmentgood.

To introduce non-Ricardian consumption behavior, we assume thatthere are two types of households in each country. "Optimizing"households maximize welfare subject to an intertemporal budgetconstraint. These households own the entire capital stock,accumulate capital subject to adjustment costs and exhibit habitpersistence in their consumption decisions. They also are regardedas monopolistic competitors in the labor market in order to accountfor aggregate wage stickiness. The other type of households ("ruleof thumb" households) simply consume their entire after-taxdisposable income.

## 2.1  Firms and Price Setting

#### Production of Domestic Intermediate Goods.

There is a continuum of monopolistically competitive firms inthe home country (indexed by ), each ofwhich produces a differentiated intermediate good. As in Betts andDevereux (1996), intermediate goods producers set prices in advancein the buyer's currency and thus may charge different prices athome and abroad (i.e., they practice local currency pricing). Inthe home market, firm  faces a demand function thatvaries inversely with its output price  anddirectly with aggregate demand at home 

|  | (1) |
|--|-----|

where , and  isan aggregate price index defined below. Similarly, in the foreignmarket, firm  faces the demand function:

|  | (2) |
|--|-----|

where  denotes the price that firm sets in the foreign market (denominated inforeign currency), while  is the foreign import price index,and  is aggregate foreign imports (weuse an asterisk to denote foreign variables).

Each producer utilizes capital services  and a labor index  (defined below) toproduce its respective output good. The production function isassumed to have a constant-elasticity of substitution (CES)form:

|  | (3) |
|--|-----|

The production function exhibits constant-returns-to-scale in bothinputs, and  is a deterministic trend in thelevel of technology that grows at the same rate  in both countries. Firms face perfectly competitivefactor markets for hiring capital and the labor index. Thus, eachfirm chooses  and , taking as given boththe rental price of capital  and theaggregate wage index  (defined below). Firmscan costlessly adjust either factor of production. Thus, thestandard static first-order conditions for cost minimization implythat all firms have identical marginal cost per unit of output,.

We assume that the home and foreign prices of the intermediategoods are determined by Calvo-style staggered contracts (see Calvo1983). In each period, a firm faces a constant probability,, of being able to reoptimize itsprice at home () and  probability of being able toreoptimize its price abroad (). These probabilities areassumed to be independent across firms, time, and countries. If afirm is not allowed to reoptimize its prices, we follow Christiano,Eichenbaum, and Evans (2001) and assume the firm resets its homeprice based on lagged aggregate inflation. Prices are updatedaccording to  where  .3Similarly, in foreign markets, if a firm can not reoptimize itsprice, the price is changed according to the rule, where . Thisform of lagged indexation is a mechanism for introducing inflationinertia into the key price-setting equations.

When a firm is allowed to reoptimize its price in the domesticmarket in period , the firm maximizes

|  | (4) |
|--|-----|

The operator  represents theconditional expectation based the information available to agentsat period . The firm discounts profits received atdate  by the state-contingent discount factor ; for notational simplicity, wehave suppressed all of the state indices.4 Also,  is defined by

|  | (5) |
|--|-----|

We define a separate profit functional for a firm's optimal choiceof its price in the foreign market at date , thatmimics equation (4).

#### Production of the Domestic Output Index.

Because households have identical Dixit-Stiglitz preferences, itis convenient to assume that a representative aggregator combinesthe differentiated intermediate products into an aggregate forhome-produced goods :

|  | (6) |
|--|-----|

The aggregator chooses the bundle of goods that minimizes the costof producing , taking the price  of each intermediategood  as given. The aggregator is also aprice-taker in the output market and sells its output at, which can be regarded as theaggregate price index for the domestically-produced good.Similarly, an aggregator combines the differentiated import goodsinto a composite import index, , which it sellsat a price, .

#### Production of Consumption and Investment Goods.

Final consumption goods are produced by a representative"consumption good distributor." This firm combines purchases ofthe domestically-produced composite good with the compositeimported good to produce a final consumption good ( according to a constant-returns-to-scale CESproduction function:

|  | (7) |
|--|-----|

where  is an index of imported goods, and  reflects costs of adjustingconsumption imports. The quasi-share parameter  may be interpreted asdetermining the degree of home bias in household consumptionexpenditure. The adjustment cost term  is assumed to take the quadraticform:

|  | (8) |
|--|-----|

This specification implies that it is costly to change the share ofthe imported good in total consumption.

Given the presence of adjustment costs, the representativeconsumption goods distributor chooses (a contingency plan for) and  to minimizeits discounted expected costs of producing the aggregateconsumption good:

|  | (9)                |
|--|--------------------|
|  |     |

The distributor sells the final consumption good to households at aprice , which may be interpreted as theconsumption price index (or equivalently, as the shadow cost ofproducing an additional unit of the consumption good).

We model the production of final investment goods in ananalogous manner. We allow for costs  that reflect costs of adjustingimports of investment goods and for a degree of home bias that maydiffer from that in the consumption aggregator. Investment goodsdistributors solve an intertemporal cost minimization problemisomorphic to that of consumption goods distributors. Thedistributor sells the final investment good to households at aprice of .

## 2.2  Households and Wage Setting

We assume a continuum of households (indexed on the unitinterval), each of which supplies a differentiated labor service tothe intermediate goods-producing sector (the only producersdemanding labor services in our framework). It is convenient toassume that a representative labor aggregator (or "employmentagency") combines households' labor hours in the same proportionsas firms would choose. Thus, the aggregator's demand for eachhousehold's labor is equal to the sum of firms' demands. Theaggregate labor index  has the Dixit-Stiglitzform:

|  | (10) |
|--|------|

where  and is hours worked by a typical member of household .Also,  is the size of a household of type and determines the size of the population.The aggregator minimizes the cost of producing a given amount ofthe aggregate labor index, taking each household's wage rate  as given, and thensells units of the labor index to the production sector at theirunit cost :

|  | (11) |
|--|------|

It is natural to interpret  as theaggregate wage index. The aggregator's demand for the laborservices of a typical member of household  is givenby

|  | (12) |
|--|------|

The utility functional of a typical member of household  is

|   |  |     |
|--------|--|--------------------|
|   |  | (13)               |

where the discount factor  satisfies As in Smets and Wouters(2003), we allow for the possibility of external habits, where anindividual in the household cares about his consumption relative tolagged aggregate consumption per capita ().The period utility function depends on current leisure  and an individual'send-of-period real money balances, . Weallow for a deterministic shift in preferences over leisure so thatthe model is consistent with balanced growth, even if thesubutility function over consumption is not logarithmic ().

We assume that there are two types of households: householdsthat make intertemporal consumption, labor supply, and capitalaccumulation decisions in a forward-looking manner by maximizingutility subject to an intertemporal budget constraint (optimizinghouseholds); and rule-of-thumb (RT) households that simply consumetheir after-tax disposable income, and choose to set their wage tobe the average wage of optimizing households. The latter type ofhouseholds receive no capital rental income or profits. We denotethe fixed share of optimizing households by .5

We consider first the problem faced by optimizing households.Each member of household  faces a flow budgetconstraint which states that his combined expenditure on goods andon the net accumulation of financial assets must equal hisdisposable income:

|  | (14) |
|--|------|

Final consumption goods are purchased at a price  and final investment goods at a price  Investment in physical capital augments the(end-of-period) capital stock  according to a linear transitionlaw of the form:

|  | (15) |
|--|------|

Financial asset accumulation of a typical member of anoptimizing household  consists of increases innominal money holdings ( and thenet acquisition of bonds. We assume that agents within a countrycan engage in frictionless trading of a complete set of contingentclaims, while trade in international assets is restricted to anon-state contingent nominal bond. The term  represents netpurchases of domestic government bonds, while  arenet purchases of state-contingent domestic bonds. We denote  as the price of an asset thatwill pay one unit of domestic currency in a particular state ofnature at date , while  represents thequantity of such claims purchased by a member of household at time . Thus, the grossoutlay on new state-contingent domestic claims is given byintegrating over all states at time , while  indicates the valueof existing claims given the realized state of nature.

In equation (14),  represents the quantity of anon-state contingent bond purchased at time t that pays one unit offoreign currency in the subsequent period,  is the foreign currency priceof the bond, and  is the exchange rate expressedin units of home currency per unit of foreign currency. We followBenigno (2001) and assume there is an intermediation cost paid by households in the homecountry for purchases of foreign bonds, which ensures that netforeign assets are stationary in the model.6

Each member of an optimizing household  earnsafter-tax labor income, ,where  is a stochastic tax on laborincome. The household leases capital to firms at the after-taxrental rate , where  is a tax on capital income. The household receives adepreciation writeoff of  per unit of capital(where  is the depreciation rate of capital).Each member also receives an aliquot share of the profitsof all firms and a government lump-sum transfer , and pays a lump-sum tax .

We allow for costs associated with adjusting the capital stock.As in Christiano, Eichenbaum, and Evans (2001), it is costly tochange the level of gross investment from the previous period, sothat the acceleration in the capital stock is penalized:

|  | (16) |
|--|------|

In every period , each member of anoptimizing household  maximizes the utilityfunctional (13) with respect toits consumption, investment, (end-of-period) capital stock, moneybalances, holdings of contingent claims, and holdings of domesticand foreign bonds, subject to its labor demand function (12), budgetconstraint (14), and transitionequation for capital (15). In doing so,a household takes as given prices, taxes, transfers, and aggregatequantities such as lagged aggregate per capita consumption and theaggregate net foreign asset position.

Optimizing households set nominal wages in staggered contractsthat are analogous to the price contracts described above. Inparticular, with probability , eachmember of a household is allowed to reoptimize his wage contract.If a household is not allowed to optimize its wage rate, we assumeeach household member must reset his price according to:

|  | (17) |
|--|------|

where  and in steadystate . Each member of household chooses the value of  to maximize his utility functional (13).

Finally, we consider the determination of consumption and laborsupply of the rule-of-thumb (RT) households. These householdssimply equate their nominal consumption spending to their currentafter-tax disposable income, which consists of labor income plusnet lump-sum transfers from the government:

|  | (18) |
|--|------|

The RT households set their wage to be the average wage of theoptimizing households. Since RT households face the same labordemand schedule as the optimizing households, each RT householdworks the same number of hours as the average for optimizinghouseholds.

## 2.3  Monetary Policy

We assume that the central bank follows an interest ratereaction function similar in form to the historical rule estimatedby Orphanides and Wieland (1998) over the Volcker-Greenspan period.Thus, the short-term nominal interest rate is adjusted so that the*ex post* real interest rate rises when inflation exceeds itsconstant target value, or when output *growth* rises abovesome target value. With some allowance for interest rate smoothing,monetary policy is described by the following interest ratereaction function:

|  | (19) |
|--|------|

In the above,  is the annualized nominal interestrate,  is the four-quarter inflationrate of domestically-produced goods (i.e., ),  and  are the steady-state realinterest rate and the central bank's constant inflation target(both expressed at annual rate). Also,  is the (annualized) quarterlygrowth rate of total output.

## 2.4  Fiscal Policy

Some of the domestically-produced good is purchased by thegovernment. Government purchases () areassumed to have no direct effect on the utility of ahousehold.7 We also assume that governmentpurchases as a fraction of total output, , follow an exogenousstochastic process.

The government can issue debt  to financea deficit so that its budget constraint is given by:

|  | (20) |
|--|------|

In equation (20)all variables are in per-capita terms.

Capital tax rates and real transfer rates (defined as ) are heldconstant. Given that the monetary authority uses the nominalinterest rate as its policy instrument, the level of seignoragerevenues are determined by nominal money demand.

Lump-sum taxes are adjusted in a manner that the governmentsatisfies an intertemporal solvency constraint, requiring that thepresent discounted value of the government debt stock tends towardzero in the long run. In particular, we assume that the reallump-sum tax rate, , isdetermined according to the following reaction function:

|  | (21) |
|--|------|

where  and is the government's target value forthe ratio of government debt to nominal output.

Government purchases as a fraction of total output,  evolve according to a first-order autoregressiveprocess:

|  | (22) |
|--|------|

where  is an identically andindependently distributed innovation. Similarly, the labor taxrate, , evolves according to afirst-order autoregression with persistence parameter .

## 2.5  Resource Constraint and Net ForeignAssets

The home economy's aggregate resource constraint can be writtenas:

|  | (23) |
|--|------|

where , and is the adjustment cost oninvestment.

The evolution of net foreign assets is derived from the budgetconstraint of the optimizing households after imposing thegovernment budget constraint, the consumption rule of the RThouseholds, the definition of firm profits, and the condition thatdomestic bonds are in zero net supply.

Finally, we assume that the structure of the foreign economy(the "rest of the world") is isomorphic to that of the homecountry.

# 3  Solution Method andCalibration

We solve the model by log-linearizing the equations around thesteady state. To obtain the reduced-form solution of the model, weuse the numerical algorithm of Anderson and Moore (1985), whichprovides an efficient implementation of the method proposed byBlanchard and Kahn (1980) (see also Anderson (1997)).8

The model is calibrated at a quarterly frequency. Structuralparameters are set at identical values for each of the twocountries, except for the parameters determining population size(as discussed below).

The utility functional parameter  is setequal to 2, while the parameter determining the degree of habitpersistence in consumption . We assume that the discountfactor  and , which is consistent with asteady-state annualized real interest rate  of roughly 4 percent and trendoutput growth of about 1.5% per year. We set , implying a Frisch elasticity of labor supply of1/5, which is considerably lower than if preferences werelogarithmic in leisure, but well within the range of most empiricalestimates. The utility parameter  is set sothat employment comprises one-third of the household's timeendowment, while the parameter  on thesubutility function for real balances is set to an arbitrarily lowvalue (so that variation in real balances has a negligible impacton other variables). Following Campbell and Mankiw (1989), wechoose  so that 50 percent ofhouseholds are optimizing agents and the rest are RTagents.9

The depreciation rate of capital  = .025(consistent with an annual depreciation rate of 10 percent). Thewage markup parameter  = 0.10, reasonably similar to thevalue estimated by Amato and Laubach (1999) of 0.13 (the pricemarkup parameter  has no effect on the linearizeddynamics). We set  and  to be consistent with four-quarter contracts (subjectto full indexation). The parameter  ischosen to be consistent with two-quarter contracts, so that thepass-through of exchange rate changes to import prices occursrelatively quickly.10 We set the steady state inflationrate  to yield an annual inflation rate offour percent.

The parameter  in the CES production functionof the intermediate goods producers is set to -2, implying anelasticity of substitution between capital and labor of 1/2. Thus,capital and labor are less substitutable than the unitaryelasticity case implied by the Cobb-Douglas specification. Thequasi-capital share parameter  is chosen to imply a steady stateinvestment to output ratio of 16 percent. The private consumptionto output ratio is 66 percent, while government consumption is 18percent of steady state output. We set the cost of adjustinginvestment parameter , close to value used byChristiano, Eichenbaum, and Evans (2001).

The parameter  is chosen to match the estimatedaverage share of imports in total U.S. consumption of about 9percent (according to NIPA data for the 1995-2003 period); whilethe parameter  is chosen to match the averageshare of imports in total U.S. investment of about 38 percent.Given that trade is balanced in steady state, this parameterizationimplies an import or export to GDP ratio for the home country (theUnited States) of about 12 percent. We choose population levels and  so that the home countryconstitutes about 25 percent of world output. This implied animport (or export) share of output of the foreign country of about4 percent.

We assume that , consistent with along-run price elasticity of demand for imported consumption andinvestment goods of 1.5. This estimate is towards the higher end ofestimates derived using macroeconomic data, which are typically inthe range of unity; nevertheless, this voluminous literature hasproduced a wide range of estimates, with the upper bound in thevicinity of 3.11 We set the adjustment cost parameter =  = 10, implying aprice-elasticity of slightly less than unity after fourquarters.12 We choose a small value (0.0001) forthe financial intermediation cost ,which is necessary to ensure the model has a unique steadystate.

We estimated the parameters of the monetary policy rule usingU.S. data from 1983:1-2003:4.13 Our estimates implied , , and . For the tax rate reactionfunction, we choose , , and . We set the steady state capital and labor taxrates equal to 0.3 and 0.2, respectively.

# 4  Rise in Government SpendingShare

Figure 3 shows the effects of an exogenous rise in the U.S.government spending share of GDP of one percentage point. Given thehigh persistence of the shock (, the government spendingshare still remains about 0.6 percentage point above steady stateafter five years (lower right panel). Initially, the primarygovernment budget deficit rises about 0.8 percentage point.14 Thedeficit is still 0.4 percentage point higher than the baselinelevel five years after the shock, reflecting that lump-sum taxrates increase very gradually given our parametrization of thetax-rate reaction function. While it may seem unrealistic to assumethat government purchases can be financed solely through adjustinglump-sum taxes, our results for the trade balance would be nearlyunchanged if we instead assumed slow adjustment of the labor taxrate.

The rise in government spending induces an immediate expansionof output. The government spending multiplier exceeds unity in theimpact period of the shock due to the sharp rise in consumption ofthe rule-of-thumb (RT) households. However, rising real interestrates quickly crowd out private investment and the consumption ofthe interest-sensitive optimizing households; the consumption ofthe latter is depressed further because of the negative wealtheffect of higher government spending. Thus, overall privateconsumption falls below baseline after only a few quarters, andmost of the output expansion is reversed. The small but morepersistent component of the output increase reflects a rise inlabor supply that is induced by the negative wealth effect.

It is interesting to note that the responses of GDP,consumption, and investment are broadly consistent with theempirical VAR evidence of Blanchard and Perotti (2002). Theseauthors find that after a government spending shock, consumptionand GDP rise, while investment falls. The peak responses of thesevariables from their VAR estimates are reasonably in line withthose in Figure 3. For example, their point estimates for the peakresponse of the government spending output multiplier range from0.9 to 1.3 in alternative specifications, slightly smaller than the1.5 percent peak response in our model. However, the VAR evidencesuggests that the responses of GDP and consumption are morepersistent than in our benchmark specification.

We next consider the effects of the government spending shock onthe external sector, which is the primary focus of our analysis.Because higher real interest rates induce an appreciation of thereal exchange rate (shown by a movement downwards in Figure 3), therelative price of imported goods falls, while the price of exportsrises in foreign markets.15 These relative price changes boostreal import demand and reduce export demand, though the response toprice changes is moderated in the short-run by adjustment costs.The positive effect on imports due to the relative price change ispartly offset by a decline in private consumption and investmentspending.

Accordingly, the quantitative magnitude of the responses of realexports and real imports depend crucially on i) the magnitude ofreal exchange rate appreciation, ii) the price elasticities ofexport and import demand, and iii) on factors that determine theresponse of private consumption and investment spending. In ourbenchmark calibration, our assumptions about the degree ofsubstitutability between home and foreign goods imply that theprice elasticities of export and import demand are each about 1after a year and 1.5 in the long-run (which is nearly attainedafter 2 years). Given that the relative price of imports in theforeign country rises about 1 percent after 2 years (essentiallythe reverse of the response of home import prices shown in theupper right panel of Figure 3), exports fall about 1-1/2 percent.Real imports rise by a somewhat more modest amount, because therelative price effect is partly offset by a contraction inconsumption and investment.

The nominal trade/GDP ratio deteriorates by about 0.15percentage point relative to baseline after about two years.Interestingly, nominal imports/GDP actually decline slightly, sincethe rise in real imports is more than offset by the fall in theirrelative price. Given that the export price converges to the priceof domestically-produced goods after a few quarters, almost all ofthe deterioration in the nominal trade balance turns out to beattributable to a fall in real exports.16

Finally, it is also helpful to consider trade adjustment fromthe saving-investment perspective embodied in the national accountsidentity:

|  | (24) |
|--|------|

where  is the nominal trade balance, is the GDP deflator, and  denotes taxes net of transfers. This relationexpresses the real trade balance as the sum of real private andpublic saving (the first and second terms in parentheses,respectively), minus real investment.17 Ceteris paribus, arise in government spending would induce government saving and thereal trade balance to deteriorate by a corresponding amount.However, in our model this aggregate demand pressure on theexternal balance is largely offset by a rise in private saving (asoutput rises and consumption eventually contracts), and by a fallin investment spending. The output expansion, consumption decline,and investment decline all play important roles in alleviating thepressure on the external balance due to the government spendinghike.

## 4.1  Sensitivity Analysis

We have shown that government spending shocks have quite modesteffects on the trade balance in our benchmark calibration. In thissection we consider the sensitivity of this result to the priceelasticity of import/export demand, the interest rate sensitivityof consumption and investment, the persistence of the shocks, thefraction of RT agents, the monetary policy rule, and theinformation structure. This analysis is helpful in comparing ourestimates of the effects on trade of government spending shockswith those of the related literature.

While the parameter  in equation(7) determines thelong-run trade price elasticity ,the parameter  in equation (8) influences theshort-run trade price elasticity. Costs of adjustment on tradeeffectively lower the short-run trade price elasticity below thelong-run level. Figure 4 compares the responses to a governmentconsumption shock under our benchmark calibration (the solid blueline), and under two alternative calibrations. The first (thedashed green line) increases the long-run trade price elasticity to3 without varying the parameter determining adjustment costs intrade; this implies that the trade elasticity after four quartersis about 1.5, rather than slightly below unity as in ourbaseline.18 The second variant (the dash-dottedred line) sets the adjustment cost parameter to zero, so that thetrade price elasticity is 3 in the impact period of the shock.

Increasing the trade elasticity stimulates greater substitutiontowards imports in the domestic market, and a larger fall indomestic exports, even allowing for a smaller real appreciation ofthe domestic currency. Nevertheless, it is interesting that themagnitude of nominal trade balance deterioration only rises toabout 0.25 percentage point of GDP in the first alternative, eventhough the implied dynamic path of the trade price elasticity ismuch higher than typically estimated using macro data.

As shown in the second variant, our model is capable ofgenerating large trade responses similar in magnitude to thosederived in the open economy RBC literature (as Baxter 1995); thus,with the short-run elasticity equal to 3, the government spendingshock induces the trade balance/GDP ratio to deteriorate by about1/2 percentage point. However, short-run trade elasticities of thismagnitude seem implausibly high. Moreover, in interpreting theseresults, it is important to keep in mind that our model impliesnearly full exchange rate pass-through to import prices after a fewquarters. In the more plausible case of incomplete pass-through,the same trade price elasticities would generate considerablysmaller effects on the trade balance.

Figure 5 considers the effects of varying model parameters thatinfluence the short-run interest sensitivity of private domesticabsorption. In our first alternative (denoted by the dashed greenline), we decreased the inter-temporal elasticity of substitutionin consumption by raising  in equation(13) from2 to 3, and also markedly increased investment adjustment costs.With a lower interest-sensitivity of private absorption, domesticinterest rates increase by a larger amount (not shown), inducing alarger initial appreciation of the real exchange rate: thus, moreof the burden of adjustment to the government spending shock isshifted to the external sector.19Nevertheless, even though ouralternative calibration would imply short-run interest rateelasticities at the low end of the macroeconomic literature, thetrade balance only deteriorates about 0.2 percentage point of GDP,only slightly more than in the benchmark calibration. Conversely,Figure 5 shows that with a logarithmic subutility function overconsumption and relatively low investment adjustment costs, thetrade balance only deteriorates about 0.1 percentage point ofGDP.

Figure 6 examines the effects of varying the persistence ofgovernment consumption shocks. In our model, less persistentgovernment spending shocks induce a less persistent rise in thereal interest rate, which causes a smaller real exchange rateappreciation and hence a smaller deterioration of the tradebalance. Thus, as illustrated by the dashed green line, the sameone percent rise in the government spending share only induces atrade balance deterioration of about 1/20 percentage point of GDPwhen the autocorrelation coefficient of the shock is reduced to0.5; moreover, as shown in a second alternative, the maximum tradebalance deterioration would only approach that in our benchmarkparameterization if there were no adjustment costs in trade.

The dashed green line in Figure 7 shows the response to apersistent government consumption shock when all households choosetheir consumption path by optimizing their utility function. Inthis case, domestic consumption falls on impact, which accounts forthe negative response of private absorption. Accordingly, the realexchange rate does not appreciate as much as under the benchmarkparametrization (the solid blue line), inducing a more modestdeterioration of the trade balance than in the benchmarkcase.20 Figure 7 also suggests that ourresults are not particularly sensitive to the choice of a monetarypolicy rule. The responses generated by adopting a Taylor rule arealmost indistinguishable from those in our benchmark case.21

Finally, we consider a case in which agents have imperfectinformation about whether the shock to government consumption ishighly persistent or transitory. As noted above, our benchmarkmodel implies significantly more rapid adjustment of output and theexpenditure components to a fiscal expansion than is implied byestimates from structural VARs, or by large-scale policy modelssuch as the FRB/Global model (see Levin et al. 1997, for adescription of this model). Accordingly, we introduce an"information friction" as a mechanism for eliciting more gradualresponses, and to help evaluate whether such changes in modelstructure have important implications for the response of the tradebalance.

More specifically, we assume that while agents can observe thecurrent shock to government consumption, they are unsure whetherthe shock is to the highly persistent component (which has anautocorrelation parameter of 0.975, as in the benchmark), or to thetransitory component (which has an autocorrelation parameter of0.5, as in the alternative cases in Figure 6). Accordingly, agentssolve a signal extraction problem by using the Kalman filter.

Figure 8 compares the case with imperfect information (thedash-dotted green line) with the benchmark case. Because agentsinitially perceive that the increase in government spending istemporary under imperfect information, there is a larger increasein GDP in this case than in the benchmark. Furthermore, the rise inGDP is more persistent, as agents only slowly update their beliefsabout the persistence of the shock and are continually surprised bythe higher-than-expected levels of government spending.Interestingly, this version of our model comes closer than thebenchmark to matching the gradual response of output (dashed redline) and private absorption implied by the FRB/Global model to thesame shock.

Given that agents expect the government spending rise to die outmore quickly under imperfect information, there is less pressure onthe exchange rate to appreciate, and correspondingly, a smallerdeterioration of the trade balance. Importantly, a rise in privatesaving plays a key role in offsetting the pressure on the externalbalance under either information structure, with the subtledifference that a rise in output rather than a fall in consumptionplays a relatively larger role in accounting for the private savingexpansion under imperfect information.

## 4.2  A Reduction in Labor Taxes

As shown in Figure 2, reductions in personal taxes have playedan even larger role than government spending hikes in accountingfor the recent deterioration in the fiscal deficit; moreover, mostof the tax declines due to policy changes reflect successivereductions in tax rates on labor income. Accordingly, it is ofinterest to consider whether fiscal deficits induced by labor taxcuts have effects on the trade balance that are broadly comparablewith those of government spending shocks.

Figure 9 shows the effects of a cut in labor tax rates that isscaled so that labor taxes would fall by one percentage point ofGDP if pre-tax labor income and output were unaffected. The shockis assumed to be highly persistent, with the autoregressiveparameter  set to 0.975. This labor taxcut induces the fiscal deficit to follow nearly the same path as inthe case of the government spending rise considered in Figure 3,with the initial fiscal deficit of nearly 1 percent of GDP fallingto around 1/2 percent after 5 years. As above, we assume thatlump-sum taxes are raised very gradually to bring the governmentdebt/GDP level back to its target level.22

The cut in labor taxes induces a sharp rise in output. Theinitial rise in output reflects that the RT households immediatelyincrease their consumption as their after-tax income expands. Thehigh level of persistence of aggregate consumption reflects thatthe consumption of the RT households remains high for an extendedduration (given that the cut to labor taxes is very persistent, andlump-sum taxes adjust slowly). Output declines from its initialpeak as rising real interest rates crowd out investment spendingand the consumption of optimizing households; however, outputremains persistently above its pre-shock level because lower taxrates induce households to work more by raising the cost ofleisure.

The channel through which the labor tax cut affects the externalsector is broadly similar to the case of the government spendingshock. In particular, higher real interest rates induce the realexchange rate to appreciate, which reduces the relative price ofimports at home, and boosts it abroad. These relative pricemovements generate a decline in real exports, and a rise inimports. The associated deterioration of the nominal trade balanceof about 0.12 percentage point of GDP is only slightly smaller thanthe decline in the case of the government spending shock; thesmaller decline in the former case reflects that the labor supplyshock stimulates output in the longer-term, which dampens theinitial appreciation of the real exchange rate.23

The quantitative effects of the labor tax cut on the tradebalance are slightly augmented under an alternative calibrationthat imposes a higher Frisch elasticity of labor supply. Figure 10compares the effects of the tax cut under the benchmark calibrationin which the Frisch elasticity is 0.2 with an alternative in whichthe Frisch elasticity is set equal to unity. The latter value ismuch higher than estimates from most microeconomic studies, but hasfrequently been utilized in the RBC literature. It is clear thatthe response of output and domestic absorption is much larger witha high labor supply elasticity, reflecting that more substitutioninto work induces a higher demand for capital, and directly boostsoutput. However, the quantitative effect on the trade balance isonly slightly larger than in our benchmark case. While a greatersurge in investment demand has the partial effect of stimulatingimport demand by more, the larger supply-side effects of the shockdampen the initial appreciation of the exchange rate.

Figure 10 also shows the implications of assuming that allagents are optimizers. Interestingly, the effect of the labor taxcut on the trade balance under this alternative are virtually nil.In the absence of RT households, there is much less upward pressureon real interest rates, so that the real exchange rate exhibits aslight initial depreciation. Thus, the size of the trade balancedeterioration in our benchmark is even more sensitive to ourassumption about the share of RT households than in the case of thegovernment spending shock.

As in the case of the government spending shock, the magnitudeof the effects of the labor tax cut on the trade balance alsodepend on the trade price elasticity. However, for an economy withstructural characteristics such as the United States, implausiblyhigh trade price elasticities would be required to elicit tradebalance deteriorations significantly larger than in our benchmarkcase. For example, even with a long-run trade price elasticity of 6(consistent with an elasticity of 2 after four quarters), the tradebalance would only deteriorate by 0.2 percentage point of GDP. Weregard this estimate as a firm upper bound on the impact of a labortax cut of the magnitude considered, because sensible modificationsto our model structure, such as a lower share of RT households orincomplete exchange rate pass-through, would be likely to reducethe effects we are reporting.

# 5  Conclusions

Our model-based analysis suggests that changes in fiscal policyhave fairly small effects on the U.S. trade balance, irrespectiveof whether the source is a spending increase or tax cut: in ourbenchmark calibration, a rise in the fiscal deficit of onepercentage point of GDP causes the trade balance to deteriorate byless than 0.2 percentage point. Most of the pressure on theexternal balance due to expansionary fiscal policy is offset by acombination of higher output, and/or a fall in private consumptionand investment.

From a policy perspective, our results suggest putting littlecredence in the idea that fiscal policy changes are likely to exertsizeable effects on the U.S. trade balance. Accordingly, fiscalcontraction in the United States is unlikely to be instrumental innarrowing the burgeoning U.S. trade deficit, even if it might bedesirable on other grounds.

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Figure 1:  The U.S. Fiscal and Trade Balance as a share of GDP

Source: NIPA.

Figure 2:  Selected Government Expenditures and Revenues as a share of GDP

Source: NIPA.

Data for Figures 1 and 2 (in percent)
| Quarter | Trade Deficit (share of GDP) | Investment (share of GDP) | Government's Net Lending, or    Borrowing (share of GDP) | Personal Current Taxes | Other    Tax Receipts  | Government Consumption and    Investment | Net Transfers |
|---------|------------------------------|---------------------------|----------------------------------------------------------|------------------------|-----------------------------|------------------------------------------|---------------|
| 0.5     | 16.9                         | 0.7                       | 8.6                                                      | 13.1                   | 20.6                        | 4.9                                      |
| 0.8     | 15.1                         | 0.1                       | 8.7                                                      | 12.8                   | 20.8                        | 5.2                                      |
| 0.8     | 14.9                         | -0.4                      | 8.8                                                      | 12.7                   | 21.4                        | 5.1                                      |
| 1.1     | 13.0                         | -1.1                      | 8.9                                                      | 12.7                   | 22.0                        | 5.4                                      |
| 1.1     | 13.3                         | -1.6                      | 8.8                                                      | 12.6                   | 22.1                        | 5.7                                      |
| 1.0     | 14.1                         | -1.7                      | 8.7                                                      | 12.7                   | 21.8                        | 5.9                                      |
| 0.7     | 15.0                         | -1.4                      | 8.6                                                      | 12.9                   | 21.9                        | 5.5                                      |
| 0.8     | 15.0                         | -1.2                      | 8.6                                                      | 13.1                   | 22.0                        | 5.4                                      |
| 0.7     | 15.5                         | -1.5                      | 8.6                                                      | 12.7                   | 22.1                        | 5.4                                      |
| 1.0     | 15.1                         | -1.4                      | 8.7                                                      | 12.6                   | 22.0                        | 5.4                                      |
| 0.7     | 15.1                         | -1.3                      | 8.9                                                      | 12.8                   | 22.3                        | 5.2                                      |
| 0.5     | 14.5                         | -1.3                      | 9.0                                                      | 12.8                   | 22.5                        | 5.4                                      |
| 0.6     | 15.0                         | -0.8                      | 9.0                                                      | 12.7                   | 22.1                        | 5.5                                      |
| 1.1     | 15.1                         | -0.4                      | 8.9                                                      | 13.0                   | 21.8                        | 5.5                                      |
| 0.6     | 15.2                         | -0.7                      | 8.8                                                      | 13.0                   | 22.3                        | 5.1                                      |
| 0.9     | 15.4                         | -0.6                      | 8.7                                                      | 13.0                   | 22.1                        | 5.2                                      |
| 1.1     | 15.5                         | -1.1                      | 8.3                                                      | 12.9                   | 21.8                        | 5.2                                      |
| 1.1     | 15.3                         | -1.8                      | 7.5                                                      | 12.9                   | 21.7                        | 5.2                                      |
| 1.0     | 15.3                         | -1.1                      | 7.7                                                      | 12.9                   | 21.5                        | 4.9                                      |
| 1.0     | 15.5                         | -0.7                      | 7.9                                                      | 12.9                   | 21.4                        | 4.9                                      |
| 0.7     | 16.6                         | 0.0                       | 8.2                                                      | 12.9                   | 20.8                        | 4.9                                      |
| 1.0     | 16.4                         | -0.1                      | 8.2                                                      | 12.8                   | 20.8                        | 5.0                                      |
| 0.7     | 16.5                         | -1.3                      | 7.9                                                      | 12.6                   | 21.2                        | 5.1                                      |
| 0.7     | 16.3                         | -1.3                      | 7.8                                                      | 12.7                   | 21.4                        | 4.8                                      |
| 0.6     | 17.1                         | -0.6                      | 8.0                                                      | 12.4                   | 21.2                        | 4.9                                      |
| 0.7     | 16.8                         | -0.6                      | 8.4                                                      | 12.5                   | 21.5                        | 5.0                                      |
| 0.3     | 16.4                         | -1.1                      | 8.6                                                      | 12.3                   | 22.1                        | 4.9                                      |
| 0.4     | 16.4                         | -1.6                      | 8.7                                                      | 12.2                   | 22.3                        | 5.3                                      |
| 0.6     | 15.8                         | -2.7                      | 8.7                                                      | 12.0                   | 23.1                        | 5.6                                      |
| 0.5     | 15.0                         | -2.6                      | 8.6                                                      | 12.0                   | 23.1                        | 5.7                                      |
| 0.3     | 15.4                         | -2.6                      | 8.8                                                      | 12.1                   | 23.2                        | 5.8                                      |
| 0.3     | 15.6                         | -2.2                      | 8.9                                                      | 12.3                   | 23.3                        | 5.8                                      |
| 0.1     | 15.6                         | -1.7                      | 8.9                                                      | 12.8                   | 23.2                        | 5.9                                      |
| 0.2     | 15.9                         | -1.9                      | 9.0                                                      | 12.7                   | 23.0                        | 6.1                                      |
| 0.1     | 15.2                         | -0.9                      | 10.0                                                     | 12.8                   | 23.0                        | 6.2                                      |
| 0.1     | 15.4                         | -0.8                      | 10.2                                                     | 12.8                   | 22.9                        | 6.2                                      |
| 0.0     | 16.2                         | 0.4                       | 10.7                                                     | 12.7                   | 22.5                        | 6.1                                      |
| 0.1     | 15.9                         | 0.4                       | 10.8                                                     | 12.6                   | 22.5                        | 6.2                                      |
| 0.1     | 16.1                         | -0.1                      | 10.4                                                     | 12.5                   | 22.6                        | 6.1                                      |
| 0.3     | 15.3                         | 0.0                       | 10.5                                                     | 12.5                   | 22.4                        | 6.3                                      |
| 0.3     | 14.8                         | -0.7                      | 10.3                                                     | 12.1                   | 22.6                        | 6.3                                      |
| 0.5     | 14.9                         | -2.0                      | 10.2                                                     | 12.1                   | 22.3                        | 7.3                                      |
| 0.4     | 14.9                         | -2.5                      | 9.6                                                      | 12.2                   | 22.4                        | 7.2                                      |
| 0.3     | 14.1                         | -3.0                      | 9.6                                                      | 12.2                   | 22.7                        | 7.6                                      |
| 0.4     | 15.6                         | -2.4                      | 9.0                                                      | 12.3                   | 22.0                        | 7.5                                      |
| 0.0     | 16.0                         | -3.1                      | 9.0                                                      | 12.3                   | 21.9                        | 8.0                                      |
| 0.0     | 16.1                         | -2.9                      | 9.0                                                      | 12.3                   | 21.8                        | 7.9                                      |
| -0.1    | 15.6                         | -2.5                      | 9.2                                                      | 12.3                   | 21.7                        | 8.0                                      |
| -0.3    | 16.2                         | -1.8                      | 10.1                                                     | 12.2                   | 21.8                        | 8.1                                      |
| -0.3    | 16.8                         | -1.5                      | 10.1                                                     | 12.0                   | 21.5                        | 7.8                                      |
| -0.2    | 17.0                         | -1.0                      | 9.9                                                      | 12.1                   | 20.9                        | 7.8                                      |
| -0.2    | 17.0                         | -0.9                      | 9.9                                                      | 12.3                   | 20.9                        | 8.2                                      |
| -0.1    | 17.4                         | -0.2                      | 9.5                                                      | 12.3                   | 20.7                        | 8.0                                      |
| 0.2     | 17.9                         | -0.7                      | 9.4                                                      | 12.1                   | 20.4                        | 8.0                                      |
| 0.5     | 17.4                         | 0.0                       | 9.6                                                      | 12.0                   | 20.2                        | 8.0                                      |
| 0.6     | 18.0                         | -0.1                      | 9.8                                                      | 11.9                   | 20.2                        | 7.9                                      |
| 0.4     | 16.9                         | -0.4                      | 9.9                                                      | 11.8                   | 20.8                        | 8.1                                      |
| -0.2    | 17.0                         | -0.2                      | 10.0                                                     | 11.8                   | 21.0                        | 8.7                                      |
| -0.5    | 16.2                         | -1.2                      | 10.2                                                     | 12.2                   | 21.3                        | 8.8                                      |
| 0.0     | 16.5                         | -2.1                      | 10.1                                                     | 11.5                   | 21.6                        | 9.0                                      |
| 1.1     | 13.9                         | -4.2                      | 10.1                                                     | 11.0                   | 22.1                        | 9.7                                      |
| 1.3     | 13.5                         | -7.2                      | 7.5                                                      | 11.2                   | 21.8                        | 10.5                                     |
| 0.7     | 14.3                         | -4.6                      | 9.2                                                      | 11.7                   | 21.8                        | 10.0                                     |
| 0.8     | 14.4                         | -4.8                      | 9.2                                                      | 11.6                   | 21.7                        | 9.9                                      |
| 0.3     | 15.5                         | -3.9                      | 9.1                                                      | 11.7                   | 21.4                        | 9.7                                      |
| 0.0     | 16.2                         | -3.2                      | 9.4                                                      | 11.6                   | 21.1                        | 9.5                                      |
| -0.2    | 16.1                         | -3.2                      | 9.6                                                      | 11.6                   | 20.8                        | 9.9                                      |
| -0.4    | 16.2                         | -3.0                      | 9.7                                                      | 11.4                   | 20.7                        | 9.5                                      |
| -1.1    | 16.8                         | -2.4                      | 9.7                                                      | 11.5                   | 20.7                        | 9.4                                      |
| -1.1    | 17.7                         | -2.2                      | 9.7                                                      | 11.6                   | 20.5                        | 9.2                                      |
| -1.0    | 18.3                         | -2.0                      | 9.6                                                      | 11.5                   | 20.2                        | 9.1                                      |
| -1.4    | 18.3                         | -2.1                      | 9.9                                                      | 11.4                   | 20.2                        | 9.0                                      |
| -1.8    | 18.5                         | -2.0                      | 9.8                                                      | 11.1                   | 20.1                        | 9.0                                      |
| -1.0    | 18.9                         | -1.0                      | 9.8                                                      | 11.4                   | 19.8                        | 8.6                                      |
| -1.0    | 19.3                         | -1.3                      | 10.1                                                     | 11.0                   | 19.7                        | 8.7                                      |
| -0.7    | 19.6                         | -1.0                      | 10.2                                                     | 11.0                   | 19.6                        | 8.5                                      |
| -0.7    | 19.5                         | -0.4                      | 10.3                                                     | 10.8                   | 19.4                        | 8.5                                      |
| -0.9    | 19.5                         | -0.8                      | 10.4                                                     | 10.6                   | 19.5                        | 8.5                                      |
| -0.9    | 19.1                         | -1.1                      | 10.6                                                     | 10.4                   | 19.5                        | 8.9                                      |
| -1.0    | 18.8                         | -1.4                      | 10.7                                                     | 10.2                   | 19.8                        | 8.9                                      |
| -1.3    | 18.5                         | -2.0                      | 10.4                                                     | 10.5                   | 20.1                        | 9.1                                      |
| -0.6    | 17.2                         | -3.0                      | 10.7                                                     | 10.0                   | 20.6                        | 9.2                                      |
| 0.2     | 15.9                         | -3.1                      | 10.8                                                     | 10.3                   | 20.4                        | 10.2                                     |
| -0.2    | 17.1                         | -2.3                      | 10.9                                                     | 10.3                   | 20.1                        | 9.8                                      |
| -0.5    | 18.4                         | -2.0                      | 10.8                                                     | 10.5                   | 20.0                        | 9.5                                      |
| -0.4    | 17.9                         | -1.9                      | 11.1                                                     | 10.3                   | 20.2                        | 9.5                                      |
| -0.2    | 18.6                         | -1.8                      | 11.2                                                     | 10.1                   | 19.8                        | 9.8                                      |
| -0.5    | 18.2                         | -3.2                      | 11.0                                                     | 9.8                    | 20.3                        | 9.8                                      |
| -0.5    | 16.5                         | -3.8                      | 11.0                                                     | 9.5                    | 20.7                        | 10.0                                     |
| -0.1    | 16.4                         | -4.1                      | 11.1                                                     | 9.4                    | 20.7                        | 10.0                                     |
| -0.9    | 16.1                         | -5.3                      | 10.7                                                     | 9.4                    | 20.9                        | 10.4                                     |
| -0.9    | 14.6                         | -6.1                      | 10.7                                                     | 9.3                    | 21.3                        | 10.8                                     |
| -0.7    | 14.7                         | -6.3                      | 10.4                                                     | 9.3                    | 21.2                        | 10.6                                     |
| -1.3    | 15.6                         | -5.3                      | 10.3                                                     | 9.7                    | 20.9                        | 10.4                                     |
| -1.8    | 16.1                         | -5.8                      | 9.6                                                      | 9.9                    | 20.8                        | 10.0                                     |
| -1.9    | 17.4                         | -5.1                      | 9.6                                                      | 9.8                    | 20.0                        | 9.9                                      |
| -2.5    | 18.6                         | -4.5                      | 9.5                                                      | 10.1                   | 20.1                        | 9.6                                      |
| -2.7    | 18.8                         | -4.5                      | 9.5                                                      | 9.9                    | 20.3                        | 9.4                                      |
| -2.6    | 18.9                         | -4.8                      | 9.6                                                      | 9.6                    | 20.2                        | 9.3                                      |
| -2.7    | 18.4                         | -5.2                      | 9.8                                                      | 9.6                    | 20.5                        | 9.5                                      |
| -2.2    | 17.5                         | -4.3                      | 10.5                                                     | 9.7                    | 20.5                        | 9.4                                      |
| -2.8    | 17.6                         | -5.6                      | 9.3                                                      | 9.6                    | 20.8                        | 9.2                                      |
| -2.8    | 17.1                         | -5.0                      | 9.9                                                      | 9.7                    | 21.0                        | 9.3                                      |
| -3.1    | 17.6                         | -5.2                      | 9.9                                                      | 9.6                    | 21.0                        | 9.3                                      |
| -2.9    | 17.4                         | -4.9                      | 9.7                                                      | 9.6                    | 21.0                        | 9.1                                      |
| -2.9    | 17.0                         | -5.4                      | 9.7                                                      | 9.6                    | 21.3                        | 9.4                                      |
| -3.1    | 16.3                         | -5.7                      | 9.8                                                      | 9.6                    | 21.5                        | 9.5                                      |
| -2.9    | 16.2                         | -4.9                      | 10.0                                                     | 9.9                    | 21.3                        | 9.3                                      |
| -3.1    | 16.6                         | -5.3                      | 9.8                                                      | 9.7                    | 21.3                        | 9.2                                      |
| -3.1    | 16.4                         | -3.8                      | 10.9                                                     | 10.1                   | 21.2                        | 9.2                                      |
| -3.1    | 16.1                         | -4.1                      | 10.2                                                     | 10.3                   | 21.0                        | 9.1                                      |
| -3.0    | 17.1                         | -4.1                      | 10.4                                                     | 10.2                   | 20.8                        | 9.0                                      |
| -2.5    | 16.1                         | -3.9                      | 10.1                                                     | 10.0                   | 20.6                        | 9.2                                      |
| -2.1    | 16.2                         | -3.7                      | 9.8                                                      | 10.1                   | 20.4                        | 9.0                                      |
| -2.0    | 16.0                         | -3.3                      | 9.8                                                      | 10.1                   | 20.2                        | 9.0                                      |
| -2.1    | 16.0                         | -3.4                      | 9.8                                                      | 10.1                   | 20.2                        | 9.0                                      |
| -1.8    | 16.5                         | -2.8                      | 10.3                                                     | 10.2                   | 19.9                        | 9.1                                      |
| -1.7    | 16.1                         | -3.0                      | 10.4                                                     | 10.0                   | 20.1                        | 9.0                                      |
| -1.4    | 15.7                         | -3.4                      | 10.3                                                     | 9.8                    | 20.1                        | 9.1                                      |
| -1.5    | 15.5                         | -3.6                      | 10.4                                                     | 9.7                    | 20.1                        | 9.3                                      |
| -1.5    | 15.4                         | -4.0                      | 10.2                                                     | 9.7                    | 20.2                        | 9.3                                      |
| -1.2    | 15.2                         | -4.0                      | 10.2                                                     | 9.7                    | 20.2                        | 9.5                                      |
| -1.3    | 14.8                         | -4.0                      | 10.2                                                     | 9.9                    | 20.2                        | 9.5                                      |
| -1.4    | 13.9                         | -5.0                      | 10.2                                                     | 9.9                    | 20.7                        | 9.6                                      |
| -0.7    | 13.4                         | -4.1                      | 9.8                                                      | 9.8                    | 20.8                        | 8.6                                      |
| -0.4    | 13.1                         | -4.9                      | 9.8                                                      | 9.8                    | 20.7                        | 9.5                                      |
| -0.4    | 13.3                         | -5.3                      | 9.7                                                      | 9.9                    | 20.5                        | 10.0                                     |
| -0.4    | 13.7                         | -5.4                      | 9.8                                                      | 10.0                   | 20.3                        | 10.5                                     |
| -0.2    | 13.1                         | -5.9                      | 9.5                                                      | 10.1                   | 20.3                        | 10.9                                     |
| -0.5    | 13.8                         | -5.8                      | 9.6                                                      | 10.1                   | 20.1                        | 11.1                                     |
| -0.6    | 13.7                         | -6.1                      | 9.6                                                      | 9.7                    | 20.0                        | 11.1                                     |
| -0.7    | 14.0                         | -5.4                      | 9.8                                                      | 9.9                    | 19.8                        | 11.1                                     |
| -0.8    | 14.2                         | -5.7                      | 9.4                                                      | 9.9                    | 19.6                        | 11.0                                     |
| -1.0    | 14.3                         | -5.0                      | 9.7                                                      | 10.1                   | 19.5                        | 11.1                                     |
| -1.1    | 14.1                         | -4.9                      | 9.8                                                      | 10.0                   | 19.3                        | 11.2                                     |
| -1.1    | 14.7                         | -4.3                      | 9.9                                                      | 10.4                   | 19.2                        | 11.2                                     |
| -1.1    | 15.1                         | -3.9                      | 9.7                                                      | 10.1                   | 18.8                        | 10.9                                     |
| -1.3    | 15.7                         | -3.3                      | 9.9                                                      | 10.4                   | 18.7                        | 10.9                                     |
| -1.4    | 15.4                         | -3.5                      | 9.7                                                      | 10.5                   | 18.9                        | 10.8                                     |
| -1.4    | 15.8                         | -3.5                      | 9.7                                                      | 10.5                   | 18.5                        | 11.0                                     |
| -1.4    | 15.9                         | -3.6                      | 9.9                                                      | 10.4                   | 18.7                        | 11.0                                     |
| -1.6    | 15.4                         | -3.4                      | 10.1                                                     | 10.4                   | 18.7                        | 11.1                                     |
| -1.1    | 15.2                         | -2.8                      | 10.1                                                     | 10.5                   | 18.5                        | 11.0                                     |
| -0.9    | 15.4                         | -2.7                      | 10.2                                                     | 10.4                   | 18.2                        | 10.8                                     |
| -1.1    | 15.3                         | -2.8                      | 10.4                                                     | 10.4                   | 18.3                        | 11.2                                     |
| -1.2    | 15.8                         | -2.3                      | 10.7                                                     | 10.4                   | 18.2                        | 11.1                                     |
| -1.5    | 16.3                         | -2.1                      | 10.7                                                     | 10.3                   | 18.0                        | 10.9                                     |
| -1.1    | 16.0                         | -1.5                      | 10.7                                                     | 10.3                   | 18.0                        | 10.6                                     |
| -1.3    | 16.2                         | -1.5                      | 11.0                                                     | 10.2                   | 17.9                        | 10.8                                     |
| -1.1    | 16.8                         | -0.8                      | 11.0                                                     | 10.3                   | 17.8                        | 10.6                                     |
| -1.2    | 16.9                         | -0.6                      | 11.2                                                     | 10.3                   | 17.6                        | 10.4                                     |
| -1.4    | 17.0                         | -0.4                      | 11.4                                                     | 10.3                   | 17.5                        | 10.6                                     |
| -1.5    | 17.5                         | 0.2                       | 11.5                                                     | 10.2                   | 17.2                        | 10.3                                     |
| -1.9    | 17.0                         | 0.4                       | 11.8                                                     | 10.1                   | 17.5                        | 10.3                                     |
| -2.0    | 17.2                         | 0.5                       | 11.8                                                     | 10.2                   | 17.4                        | 10.2                                     |
| -1.9    | 17.3                         | 0.6                       | 11.8                                                     | 10.0                   | 17.3                        | 10.1                                     |
| -2.3    | 17.6                         | 0.7                       | 11.8                                                     | 10.0                   | 17.4                        | 10.1                                     |
| -2.7    | 17.3                         | 0.9                       | 11.9                                                     | 10.0                   | 17.4                        | 10.0                                     |
| -3.1    | 17.5                         | 0.9                       | 12.0                                                     | 10.0                   | 17.5                        | 9.9                                      |
| -3.1    | 17.7                         | 0.9                       | 12.1                                                     | 10.0                   | 17.6                        | 9.9                                      |
| -3.6    | 17.4                         | 1.9                       | 12.5                                                     | 10.1                   | 17.5                        | 9.8                                      |
| -3.7    | 18.1                         | 1.6                       | 12.5                                                     | 9.9                    | 17.5                        | 9.8                                      |
| -4.1    | 17.7                         | 1.6                       | 12.7                                                     | 9.8                    | 17.5                        | 9.9                                      |
| -4.1    | 17.5                         | 1.3                       | 12.6                                                     | 9.7                    | 17.6                        | 10.0                                     |
| -3.9    | 16.7                         | 1.1                       | 12.9                                                     | 9.4                    | 17.8                        | 10.2                                     |
| -3.6    | 16.3                         | 0.5                       | 13.0                                                     | 9.3                    | 18.0                        | 10.4                                     |
| -3.6    | 15.9                         | -1.8                      | 11.0                                                     | 9.1                    | 18.0                        | 10.4                                     |
| -3.4    | 14.9                         | -1.3                      | 12.0                                                     | 8.9                    | 18.3                        | 10.8                                     |
| -3.6    | 15.2                         | -3.3                      | 10.3                                                     | 8.8                    | 18.5                        | 11.1                                     |
| -4.0    | 15.1                         | -3.7                      | 10.1                                                     | 9.0                    | 18.6                        | 11.1                                     |
| -4.1    | 15.0                         | -3.7                      | 9.9                                                      | 9.1                    | 18.7                        | 11.1                                     |
| -4.5    | 15.0                         | -4.3                      | 9.8                                                      | 9.1                    | 18.9                        | 11.1                                     |
| -4.7    | 14.9                         | -4.3                      | 9.5                                                      | 9.4                    | 19.0                        | 11.2                                     |
| -4.6    | 14.8                         | -4.7                      | 9.5                                                      | 9.4                    | 19.1                        | 11.2                                     |
| -4.4    | 15.3                         | -5.1                      | 8.5                                                      | 9.4                    | 18.8                        | 11.1                                     |
| -4.5    | 15.6                         | -4.3                      | 9.0                                                      | 9.4                    | 18.6                        | 10.9                                     |
| -4.8    | 15.9                         | -4.5                      | 8.8                                                      | 9.4                    | 18.6                        | 11.1                                     |
| -5.1    | 16.5                         | -4.4                      | 8.8                                                      | 9.5                    | 18.7                        | 11.0                                     |

Figure 3:  Rise in Government Spending (benchmark calibration)

Data for Figure 3
| Quarter | GDP   | Consumption | Investment | Real exchange rate | Real interest rate | Relative price of imports | Exports | Imports | Trade/GDP | Govt Spending/GDP | Govt Deficit/GDP |
|---------|-------|-------------|------------|--------------------|--------------------|---------------------------|---------|---------|-----------|-------------------|------------------|
| 1.54    | 0.67  | -0.44       | -2.17      | 0.05               | -0.76              | -0.47                     | 0.44    | -0.17   | 1.00      | 0.82              |
| 1.13    | 0.34  | -0.69       | -2.15      | 0.39               | -1.54              | -0.88                     | 0.46    | -0.02   | 0.98      | 0.84              |
| 0.81    | 0.08  | -0.82       | -2.05      | 0.71               | -2.00              | -1.20                     | 0.52    | 0.05    | 0.95      | 0.85              |
| 0.58    | -0.12 | -0.85       | -1.88      | 0.97               | -2.10              | -1.41                     | 0.58    | 0.06    | 0.93      | 0.84              |
| 0.42    | -0.25 | -0.84       | -1.65      | 0.71               | -1.94              | -1.53                     | 0.64    | 0.01    | 0.90      | 0.83              |
| 0.32    | -0.33 | -0.81       | -1.48      | 0.54               | -1.69              | -1.58                     | 0.67    | -0.04   | 0.88      | 0.81              |
| 0.27    | -0.37 | -0.77       | -1.36      | 0.43               | -1.45              | -1.59                     | 0.68    | -0.10   | 0.86      | 0.78              |
| 0.23    | -0.39 | -0.72       | -1.28      | 0.34               | -1.28              | -1.57                     | 0.70    | -0.13   | 0.84      | 0.75              |
| 0.21    | -0.40 | -0.67       | -1.21      | 0.27               | -1.17              | -1.55                     | 0.71    | -0.14   | 0.82      | 0.72              |
| 0.20    | -0.40 | -0.62       | -1.16      | 0.21               | -1.11              | -1.53                     | 0.72    | -0.15   | 0.80      | 0.69              |
| 0.19    | -0.39 | -0.57       | -1.12      | 0.17               | -1.08              | -1.51                     | 0.73    | -0.14   | 0.78      | 0.66              |
| 0.18    | -0.39 | -0.53       | -1.08      | 0.15               | -1.07              | -1.49                     | 0.73    | -0.14   | 0.76      | 0.63              |
| 0.17    | -0.39 | -0.49       | -1.06      | 0.14               | -1.05              | -1.47                     | 0.73    | -0.14   | 0.74      | 0.60              |
| 0.16    | -0.39 | -0.45       | -1.03      | 0.14               | -1.03              | -1.44                     | 0.72    | -0.13   | 0.72      | 0.58              |
| 0.14    | -0.40 | -0.42       | -1.00      | 0.14               | -1.01              | -1.41                     | 0.71    | -0.13   | 0.70      | 0.55              |
| 0.13    | -0.40 | -0.40       | -0.98      | 0.15               | -0.98              | -1.38                     | 0.69    | -0.13   | 0.68      | 0.53              |
| 0.12    | -0.40 | -0.37       | -0.95      | 0.15               | -0.95              | -1.35                     | 0.68    | -0.13   | 0.67      | 0.51              |
| 0.11    | -0.41 | -0.35       | -0.92      | 0.16               | -0.92              | -1.31                     | 0.66    | -0.13   | 0.65      | 0.48              |
| 0.10    | -0.41 | -0.33       | -0.89      | 0.16               | -0.89              | -1.27                     | 0.64    | -0.12   | 0.63      | 0.46              |
| 0.10    | -0.41 | -0.30       | -0.85      | 0.16               | -0.85              | -1.24                     | 0.62    | -0.12   | 0.62      | 0.44              |

Figure 4:  Rise in Government Spending (different trade price elasticities)

Data for Figure 4
| Quarter | Benchmark: Real GDP | Benchmark: Real Exchange Rate | Benchmark: Private Absorption | Benchmark: Trade Balance /GDP | LR trade elas = 3: Real GDP | LR trade elas = 3: Real Exchange Rate | LR trade elas = 3: Private Absorption | LR trade elas = 3: Trade Balance /GDP | SR trade elas = 3: Real GDP | SR trade elas = 3: Real Exchange Rate | SR trade elas = 3: Private Absorption | SR trade elas = 3: Trade Balance /GDP |
|---------|---------------------|-------------------------------|-------------------------------|-------------------------------|-----------------------------|---------------------------------------|---------------------------------------|---------------------------------------|-----------------------------|---------------------------------------|---------------------------------------|---------------------------------------|
| 1.54    | -2.17               | 0.46                          | -0.17                         | 1.54                          | -1.71                       | 0.46                                  | -0.16                                 | 1.32                                  | -1.11                       | 0.42                                  | -0.29                                 |
| 1.13    | -2.15               | 0.14                          | -0.02                         | 1.13                          | -1.70                       | 0.15                                  | -0.05                                 | 0.72                                  | -1.07                       | 0.06                                  | -0.36                                 |
| 0.81    | -2.05               | -0.10                         | 0.05                          | 0.80                          | -1.60                       | -0.09                                 | -0.01                                 | 0.35                                  | -0.97                       | -0.17                                 | -0.39                                 |
| 0.58    | -1.88               | -0.26                         | 0.06                          | 0.56                          | -1.43                       | -0.26                                 | -0.03                                 | 0.19                                  | -0.86                       | -0.28                                 | -0.40                                 |
| 0.42    | -1.65               | -0.36                         | 0.01                          | 0.39                          | -1.19                       | -0.36                                 | -0.07                                 | 0.17                                  | -0.74                       | -0.32                                 | -0.38                                 |
| 0.32    | -1.48               | -0.42                         | -0.04                         | 0.29                          | -1.03                       | -0.42                                 | -0.14                                 | 0.20                                  | -0.71                       | -0.33                                 | -0.35                                 |
| 0.27    | -1.36               | -0.45                         | -0.10                         | 0.22                          | -0.92                       | -0.45                                 | -0.19                                 | 0.22                                  | -0.71                       | -0.33                                 | -0.33                                 |
| 0.23    | -1.28               | -0.46                         | -0.13                         | 0.19                          | -0.83                       | -0.45                                 | -0.22                                 | 0.22                                  | -0.70                       | -0.33                                 | -0.31                                 |
| 0.21    | -1.21               | -0.45                         | -0.14                         | 0.16                          | -0.77                       | -0.44                                 | -0.24                                 | 0.21                                  | -0.68                       | -0.34                                 | -0.30                                 |
| 0.20    | -1.16               | -0.44                         | -0.15                         | 0.15                          | -0.73                       | -0.43                                 | -0.25                                 | 0.19                                  | -0.65                       | -0.34                                 | -0.28                                 |
| 0.19    | -1.12               | -0.43                         | -0.14                         | 0.14                          | -0.69                       | -0.42                                 | -0.25                                 | 0.18                                  | -0.62                       | -0.35                                 | -0.27                                 |
| 0.18    | -1.08               | -0.42                         | -0.14                         | 0.13                          | -0.67                       | -0.40                                 | -0.24                                 | 0.17                                  | -0.59                       | -0.35                                 | -0.26                                 |
| 0.17    | -1.06               | -0.41                         | -0.14                         | 0.12                          | -0.65                       | -0.40                                 | -0.24                                 | 0.16                                  | -0.57                       | -0.35                                 | -0.25                                 |
| 0.16    | -1.03               | -0.41                         | -0.13                         | 0.10                          | -0.63                       | -0.39                                 | -0.24                                 | 0.15                                  | -0.55                       | -0.35                                 | -0.24                                 |
| 0.14    | -1.00               | -0.40                         | -0.13                         | 0.09                          | -0.61                       | -0.38                                 | -0.24                                 | 0.14                                  | -0.53                       | -0.35                                 | -0.23                                 |
| 0.13    | -0.98               | -0.40                         | -0.13                         | 0.08                          | -0.59                       | -0.38                                 | -0.23                                 | 0.13                                  | -0.51                       | -0.35                                 | -0.22                                 |
| 0.12    | -0.95               | -0.40                         | -0.13                         | 0.07                          | -0.57                       | -0.37                                 | -0.23                                 | 0.13                                  | -0.49                       | -0.35                                 | -0.22                                 |
| 0.11    | -0.92               | -0.39                         | -0.13                         | 0.07                          | -0.55                       | -0.37                                 | -0.23                                 | 0.12                                  | -0.48                       | -0.35                                 | -0.21                                 |
| 0.10    | -0.89               | -0.39                         | -0.12                         | 0.06                          | -0.53                       | -0.36                                 | -0.22                                 | 0.11                                  | -0.46                       | -0.35                                 | -0.20                                 |
| 0.10    | -0.85               | -0.39                         | -0.12                         | 0.06                          | -0.50                       | -0.36                                 | -0.22                                 | 0.10                                  | -0.44                       | -0.35                                 | -0.19                                 |

Figure 5:  Rise in Government Spending (different interest elasticities)

Data for Figure 5
| Quarter | Benchmark: Real GDP | Benchmark: Real Exchange Rate | Benchmark: Private Absorption | Benchmark: Trade Balance /GDP | Low SR interest elas : Real GDP | Low SR interest elas: Real Exchange Rate | Low SR interest elas: Private Absorption | Low SR interest elas: Trade Balance /GDP | High SR interest elas: Real GDP | High SR interest elas: Real Exchange Rate | High SR interest elas: Private Absorption | High SR interest elas: Trade Balance /GDP |
|---------|---------------------|-------------------------------|-------------------------------|-------------------------------|---------------------------------|------------------------------------------|------------------------------------------|------------------------------------------|---------------------------------|-------------------------------------------|-------------------------------------------|-------------------------------------------|
| 1.54    | -2.17               | 0.46                          | -0.17                         | 1.61                          | -2.36                           | 0.56                                     | -0.20                                    | 1.36                                     | -1.76                           | 0.19                                      | -0.09                                     |
| 1.13    | -2.15               | 0.14                          | -0.02                         | 1.23                          | -2.35                           | 0.29                                     | -0.05                                    | 0.89                                     | -1.74                           | -0.24                                     | 0.06                                      |
| 0.81    | -2.05               | -0.10                         | 0.05                          | 0.92                          | -2.25                           | 0.08                                     | 0.02                                     | 0.57                                     | -1.65                           | -0.49                                     | 0.13                                      |
| 0.58    | -1.88               | -0.26                         | 0.06                          | 0.69                          | -2.06                           | -0.08                                    | 0.02                                     | 0.36                                     | -1.50                           | -0.63                                     | 0.12                                      |
| 0.42    | -1.65               | -0.36                         | 0.01                          | 0.52                          | -1.81                           | -0.19                                    | -0.02                                    | 0.25                                     | -1.32                           | -0.68                                     | 0.08                                      |
| 0.32    | -1.48               | -0.42                         | -0.04                         | 0.41                          | -1.62                           | -0.26                                    | -0.08                                    | 0.18                                     | -1.20                           | -0.69                                     | 0.02                                      |
| 0.27    | -1.36               | -0.45                         | -0.10                         | 0.35                          | -1.48                           | -0.30                                    | -0.13                                    | 0.14                                     | -1.13                           | -0.69                                     | -0.03                                     |
| 0.23    | -1.28               | -0.46                         | -0.13                         | 0.31                          | -1.37                           | -0.32                                    | -0.16                                    | 0.12                                     | -1.08                           | -0.67                                     | -0.07                                     |
| 0.21    | -1.21               | -0.45                         | -0.14                         | 0.28                          | -1.29                           | -0.33                                    | -0.18                                    | 0.11                                     | -1.03                           | -0.65                                     | -0.09                                     |
| 0.20    | -1.16               | -0.44                         | -0.15                         | 0.27                          | -1.22                           | -0.33                                    | -0.18                                    | 0.11                                     | -1.00                           | -0.61                                     | -0.10                                     |
| 0.19    | -1.12               | -0.43                         | -0.14                         | 0.25                          | -1.17                           | -0.32                                    | -0.17                                    | 0.10                                     | -0.97                           | -0.59                                     | -0.10                                     |
| 0.18    | -1.08               | -0.42                         | -0.14                         | 0.24                          | -1.14                           | -0.32                                    | -0.17                                    | 0.10                                     | -0.94                           | -0.56                                     | -0.10                                     |
| 0.17    | -1.06               | -0.41                         | -0.14                         | 0.22                          | -1.10                           | -0.32                                    | -0.16                                    | 0.10                                     | -0.92                           | -0.54                                     | -0.11                                     |
| 0.16    | -1.03               | -0.41                         | -0.13                         | 0.21                          | -1.07                           | -0.32                                    | -0.15                                    | 0.09                                     | -0.89                           | -0.52                                     | -0.11                                     |
| 0.14    | -1.00               | -0.40                         | -0.13                         | 0.19                          | -1.05                           | -0.33                                    | -0.15                                    | 0.08                                     | -0.86                           | -0.51                                     | -0.11                                     |
| 0.13    | -0.98               | -0.40                         | -0.13                         | 0.18                          | -1.02                           | -0.33                                    | -0.14                                    | 0.08                                     | -0.84                           | -0.50                                     | -0.11                                     |
| 0.12    | -0.95               | -0.40                         | -0.13                         | 0.16                          | -0.99                           | -0.33                                    | -0.14                                    | 0.07                                     | -0.81                           | -0.49                                     | -0.11                                     |
| 0.11    | -0.92               | -0.39                         | -0.13                         | 0.15                          | -0.95                           | -0.34                                    | -0.14                                    | 0.07                                     | -0.78                           | -0.48                                     | -0.11                                     |
| 0.10    | -0.89               | -0.39                         | -0.12                         | 0.14                          | -0.92                           | -0.34                                    | -0.13                                    | 0.06                                     | -0.76                           | -0.47                                     | -0.10                                     |
| 0.10    | -0.85               | -0.39                         | -0.12                         | 0.13                          | -0.88                           | -0.34                                    | -0.13                                    | 0.06                                     | -0.73                           | -0.46                                     | -0.10                                     |

Figure 6:  Rise in Government Spending (less persistent shock)

Data for Figure 6
| Quarter | Benchmark: Real GDP | Benchmark: Real Exchange Rate | Benchmark: Private Absorption | Benchmark: Trade Balance /GDP | Less persistent shocks: Real GDP | Less persistent shocks: Real Exchange Rate | Less persistent shocks: Private Absorption | Less persistent shocks: Trade Balance /GDP | Persistence = .5, high SR elas: Real GDP | Persistence = .5, high SR elas: Real Exchange Rate | Persistence = .5, high SR elas: Private Absorption | Persistence = .5, high SR elas: Trade Balance /GDP |
|---------|---------------------|-------------------------------|-------------------------------|-------------------------------|----------------------------------|--------------------------------------------|--------------------------------------------|--------------------------------------------|------------------------------------------|----------------------------------------------------|----------------------------------------------------|----------------------------------------------------|
| 1.54    | -2.17               | 0.46                          | -0.17                         | 1.88                          | -0.52                            | 0.73                                       | -0.06                                      | 1.74                                       | -0.39                                    | 0.68                                               | -0.13                                              |
| 1.13    | -2.15               | 0.14                          | -0.02                         | 0.81                          | -0.45                            | 0.24                                       | 0.02                                       | 0.59                                       | -0.31                                    | 0.16                                               | -0.11                                              |
| 0.81    | -2.05               | -0.10                         | 0.05                          | 0.29                          | -0.32                            | 0.00                                       | 0.05                                       | 0.10                                       | -0.19                                    | -0.06                                              | -0.08                                              |
| 0.58    | -1.88               | -0.26                         | 0.06                          | 0.06                          | -0.15                            | -0.09                                      | 0.04                                       | -0.04                                      | -0.06                                    | -0.11                                              | -0.04                                              |
| 0.42    | -1.65               | -0.36                         | 0.01                          | -0.02                         | 0.04                             | -0.10                                      | 0.02                                       | -0.03                                      | 0.06                                     | -0.08                                              | -0.01                                              |
| 0.32    | -1.48               | -0.42                         | -0.04                         | -0.04                         | 0.08                             | -0.08                                      | 0.00                                       | 0.01                                       | 0.05                                     | -0.05                                              | 0.01                                               |
| 0.27    | -1.36               | -0.45                         | -0.10                         | -0.04                         | 0.08                             | -0.06                                      | -0.02                                      | 0.03                                       | 0.02                                     | -0.03                                              | 0.02                                               |
| 0.23    | -1.28               | -0.46                         | -0.13                         | -0.03                         | 0.06                             | -0.04                                      | -0.02                                      | 0.02                                       | 0.00                                     | -0.02                                              | 0.02                                               |
| 0.21    | -1.21               | -0.45                         | -0.14                         | -0.02                         | 0.03                             | -0.03                                      | -0.01                                      | 0.01                                       | 0.00                                     | -0.02                                              | 0.01                                               |
| 0.20    | -1.16               | -0.44                         | -0.15                         | -0.02                         | 0.01                             | -0.02                                      | -0.01                                      | -0.01                                      | 0.00                                     | -0.03                                              | 0.01                                               |
| 0.19    | -1.12               | -0.43                         | -0.14                         | -0.02                         | -0.01                            | -0.02                                      | 0.00                                       | -0.02                                      | 0.00                                     | -0.03                                              | 0.01                                               |
| 0.18    | -1.08               | -0.42                         | -0.14                         | -0.02                         | -0.02                            | -0.02                                      | 0.00                                       | -0.03                                      | 0.00                                     | -0.03                                              | 0.00                                               |
| 0.17    | -1.06               | -0.41                         | -0.14                         | -0.03                         | -0.03                            | -0.03                                      | 0.01                                       | -0.03                                      | 0.00                                     | -0.03                                              | 0.00                                               |
| 0.16    | -1.03               | -0.41                         | -0.13                         | -0.03                         | -0.04                            | -0.03                                      | 0.01                                       | -0.03                                      | -0.01                                    | -0.03                                              | 0.00                                               |
| 0.14    | -1.00               | -0.40                         | -0.13                         | -0.04                         | -0.04                            | -0.03                                      | 0.01                                       | -0.03                                      | -0.01                                    | -0.03                                              | 0.00                                               |
| 0.13    | -0.98               | -0.40                         | -0.13                         | -0.04                         | -0.04                            | -0.04                                      | 0.00                                       | -0.03                                      | -0.01                                    | -0.03                                              | 0.00                                               |
| 0.12    | -0.95               | -0.40                         | -0.13                         | -0.04                         | -0.03                            | -0.04                                      | 0.00                                       | -0.03                                      | -0.01                                    | -0.03                                              | 0.00                                               |
| 0.11    | -0.92               | -0.39                         | -0.13                         | -0.04                         | -0.03                            | -0.04                                      | 0.00                                       | -0.03                                      | -0.01                                    | -0.03                                              | 0.00                                               |
| 0.10    | -0.89               | -0.39                         | -0.12                         | -0.04                         | -0.02                            | -0.03                                      | 0.00                                       | -0.03                                      | -0.01                                    | -0.03                                              | 0.00                                               |
| 0.10    | -0.85               | -0.39                         | -0.12                         | -0.03                         | -0.02                            | -0.03                                      | 0.00                                       | -0.03                                      | -0.01                                    | -0.03                                              | 0.00                                               |

Figure 7:  Rise in Government Spending (alternative calibrations)

Data for Figure 7
| Quarter | Benchmark: Real GDP | Benchmark: Real Exchange Rate | Benchmark: Private Absorption | Benchmark: Trade Balance /GDP | All house- holds optimize: Real GDP | All house- holds optimize: Real Exchange Rate | All house- holds optimize: Private Absorption | All house- holds optimize: Trade Balance /GDP | Taylor Rule: Real GDP | Taylor Rule: Real Exchange Rate | Taylor Rule: Private Absorption | Taylor Rule: Trade Balance /GDP |
|---------|---------------------|-------------------------------|-------------------------------|-------------------------------|-------------------------------------|-----------------------------------------------|-----------------------------------------------|-----------------------------------------------|-----------------------|---------------------------------|---------------------------------|---------------------------------|
| 1.54    | -2.17               | 0.46                          | -0.17                         | 0.96                          | -1.58                               | -0.21                                         | -0.09                                         | 1.56                                          | -2.12                 | 0.47                            | -0.17                           |
| 1.13    | -2.15               | 0.14                          | -0.02                         | 0.72                          | -1.57                               | -0.36                                         | 0.01                                          | 1.17                                          | -2.01                 | 0.18                            | -0.02                           |
| 0.81    | -2.05               | -0.10                         | 0.05                          | 0.54                          | -1.51                               | -0.46                                         | 0.06                                          | 0.86                                          | -1.91                 | -0.04                           | 0.05                            |
| 0.58    | -1.88               | -0.26                         | 0.06                          | 0.41                          | -1.40                               | -0.53                                         | 0.06                                          | 0.63                                          | -1.79                 | -0.21                           | 0.04                            |
| 0.42    | -1.65               | -0.36                         | 0.01                          | 0.33                          | -1.24                               | -0.56                                         | 0.03                                          | 0.47                                          | -1.64                 | -0.32                           | 0.00                            |
| 0.32    | -1.48               | -0.42                         | -0.04                         | 0.27                          | -1.13                               | -0.57                                         | -0.02                                         | 0.36                                          | -1.49                 | -0.39                           | -0.05                           |
| 0.27    | -1.36               | -0.45                         | -0.10                         | 0.23                          | -1.04                               | -0.58                                         | -0.06                                         | 0.29                                          | -1.37                 | -0.42                           | -0.10                           |
| 0.23    | -1.28               | -0.46                         | -0.13                         | 0.21                          | -0.97                               | -0.57                                         | -0.08                                         | 0.25                                          | -1.28                 | -0.44                           | -0.12                           |
| 0.21    | -1.21               | -0.45                         | -0.14                         | 0.20                          | -0.91                               | -0.56                                         | -0.10                                         | 0.23                                          | -1.21                 | -0.44                           | -0.14                           |
| 0.20    | -1.16               | -0.44                         | -0.15                         | 0.19                          | -0.87                               | -0.54                                         | -0.10                                         | 0.21                                          | -1.16                 | -0.43                           | -0.14                           |
| 0.19    | -1.12               | -0.43                         | -0.14                         | 0.18                          | -0.83                               | -0.53                                         | -0.10                                         | 0.19                                          | -1.13                 | -0.43                           | -0.14                           |
| 0.18    | -1.08               | -0.42                         | -0.14                         | 0.18                          | -0.80                               | -0.51                                         | -0.10                                         | 0.18                                          | -1.09                 | -0.42                           | -0.14                           |
| 0.17    | -1.06               | -0.41                         | -0.14                         | 0.17                          | -0.78                               | -0.50                                         | -0.10                                         | 0.17                                          | -1.07                 | -0.41                           | -0.13                           |
| 0.16    | -1.03               | -0.41                         | -0.13                         | 0.16                          | -0.76                               | -0.48                                         | -0.10                                         | 0.15                                          | -1.04                 | -0.41                           | -0.13                           |
| 0.14    | -1.00               | -0.40                         | -0.13                         | 0.16                          | -0.74                               | -0.47                                         | -0.10                                         | 0.14                                          | -1.01                 | -0.41                           | -0.13                           |
| 0.13    | -0.98               | -0.40                         | -0.13                         | 0.15                          | -0.72                               | -0.46                                         | -0.10                                         | 0.13                                          | -0.97                 | -0.40                           | -0.13                           |
| 0.12    | -0.95               | -0.40                         | -0.13                         | 0.15                          | -0.70                               | -0.45                                         | -0.09                                         | 0.12                                          | -0.94                 | -0.40                           | -0.13                           |
| 0.11    | -0.92               | -0.39                         | -0.13                         | 0.14                          | -0.68                               | -0.44                                         | -0.09                                         | 0.11                                          | -0.91                 | -0.39                           | -0.12                           |
| 0.10    | -0.89               | -0.39                         | -0.12                         | 0.14                          | -0.66                               | -0.43                                         | -0.09                                         | 0.11                                          | -0.87                 | -0.39                           | -0.12                           |
| 0.10    | -0.85               | -0.39                         | -0.12                         | 0.13                          | -0.64                               | -0.42                                         | -0.09                                         | 0.10                                          | -0.84                 | -0.38                           | -0.12                           |

Figure 8:  Rise in Government Spending (imperfect information)

Data for Figure 8
| Quarter | Benchmark: Real GDP | Benchmark: Real Exchange Rate | Benchmark: Private Absorption | Benchmark: Trade Balance /GDP | Imperfect Info : Real GDP | Imperfect Info: Real Exchange Rate | Imperfect Info: Private Absorption | Imperfect Info: Trade Balance /GDP | FRB / Global: Real GDP | FRB / Global: Real Exchange Rate | FRB / Global: Private Absorption | FRB / Global: Trade Balance /GDP |
|---------|---------------------|-------------------------------|-------------------------------|-------------------------------|---------------------------|------------------------------------|------------------------------------|------------------------------------|------------------------|----------------------------------|----------------------------------|----------------------------------|
| 1.54    | -2.17               | 0.46                          | -0.17                         | 1.88                          | -0.51                     | 0.74                               | -0.16                              | 0.89                               | 0.00                   | 0.05                             | -0.06                            |
| 1.13    | -2.15               | 0.14                          | -0.02                         | 1.70                          | -0.75                     | 0.59                               | -0.05                              | 0.85                               | 0.24                   | -0.04                            | -0.16                            |
| 0.81    | -2.05               | -0.10                         | 0.05                          | 1.53                          | -0.86                     | 0.46                               | -0.01                              | 0.80                               | 0.38                   | -0.10                            | -0.16                            |
| 0.58    | -1.88               | -0.26                         | 0.06                          | 1.39                          | -0.87                     | 0.35                               | -0.03                              | 0.63                               | 0.48                   | -0.17                            | -0.21                            |
| 0.42    | -1.65               | -0.36                         | 0.01                          | 1.28                          | -0.77                     | 0.28                               | -0.07                              | 0.67                               | 0.48                   | -0.20                            | -0.22                            |
| 0.32    | -1.48               | -0.42                         | -0.04                         | 1.18                          | -0.71                     | 0.22                               | -0.14                              | 0.57                               | 0.48                   | -0.22                            | -0.23                            |
| 0.27    | -1.36               | -0.45                         | -0.10                         | 1.11                          | -0.69                     | 0.17                               | -0.19                              | 0.56                               | 0.46                   | -0.23                            | -0.21                            |
| 0.23    | -1.28               | -0.46                         | -0.13                         | 1.04                          | -0.68                     | 0.14                               | -0.22                              | 0.58                               | 0.46                   | -0.24                            | -0.17                            |
| 0.21    | -1.21               | -0.45                         | -0.14                         | 0.98                          | -0.68                     | 0.11                               | -0.24                              | 0.59                               | 0.49                   | -0.26                            | -0.14                            |
| 0.20    | -1.16               | -0.44                         | -0.15                         | 0.91                          | -0.69                     | 0.07                               | -0.25                              | 0.60                               | 0.52                   | -0.27                            | -0.11                            |
| 0.19    | -1.12               | -0.43                         | -0.14                         | 0.85                          | -0.70                     | 0.04                               | -0.25                              | 0.58                               | 0.57                   | -0.29                            | -0.10                            |
| 0.18    | -1.08               | -0.42                         | -0.14                         | 0.79                          | -0.72                     | 0.01                               | -0.24                              | 0.56                               | 0.60                   | -0.32                            | -0.09                            |
| 0.17    | -1.06               | -0.41                         | -0.14                         | 0.73                          | -0.74                     | -0.02                              | -0.24                              | 0.53                               | 0.63                   | -0.34                            | -0.10                            |
| 0.16    | -1.03               | -0.41                         | -0.13                         | 0.67                          | -0.75                     | -0.05                              | -0.24                              | 0.50                               | 0.65                   | -0.36                            | -0.11                            |
| 0.14    | -1.00               | -0.40                         | -0.13                         | 0.61                          | -0.76                     | -0.09                              | -0.24                              | 0.47                               | 0.67                   | -0.37                            | -0.11                            |
| 0.13    | -0.98               | -0.40                         | -0.13                         | 0.56                          | -0.77                     | -0.12                              | -0.23                              | 0.45                               | 0.69                   | -0.39                            | -0.11                            |

Figure 9:  Fall in Labor tax rate (benchmark calibration)

Data for Figure 9
| Quarter | GDP  | Consumption | Investment | Real exchange rate | Real interest rate | Relative price of imports | Exports | Imports | Trade       /GDP | Govt Spending       /GDP | Govt Deficit       /GDP |
|---------|------|-------------|------------|--------------------|--------------------|---------------------------|---------|---------|------------------|--------------------------|-------------------------|
| 0.73    | 1.08 | -0.17       | -0.94      | 0.04               | -0.33              | -0.19                     | 0.59    | -0.12   | 0.00             | 0.91                     |
| 0.56    | 0.93 | -0.25       | -0.93      | 0.21               | -0.66              | -0.37                     | 0.59    | -0.06   | 0.00             | 0.91                     |
| 0.43    | 0.81 | -0.28       | -0.88      | 0.37               | -0.85              | -0.50                     | 0.62    | -0.02   | 0.00             | 0.90                     |
| 0.34    | 0.71 | -0.26       | -0.79      | 0.51               | -0.88              | -0.59                     | 0.64    | -0.02   | 0.00             | 0.88                     |
| 0.29    | 0.65 | -0.21       | -0.67      | 0.39               | -0.80              | -0.63                     | 0.67    | -0.04   | 0.00             | 0.86                     |
| 0.26    | 0.60 | -0.16       | -0.58      | 0.32               | -0.68              | -0.63                     | 0.69    | -0.07   | 0.00             | 0.84                     |
| 0.25    | 0.58 | -0.11       | -0.51      | 0.26               | -0.55              | -0.63                     | 0.70    | -0.09   | 0.00             | 0.82                     |
| 0.25    | 0.56 | -0.05       | -0.46      | 0.21               | -0.46              | -0.61                     | 0.71    | -0.11   | 0.00             | 0.79                     |
| 0.25    | 0.55 | -0.01       | -0.42      | 0.16               | -0.40              | -0.59                     | 0.71    | -0.11   | 0.00             | 0.76                     |
| 0.26    | 0.55 | 0.04        | -0.38      | 0.13               | -0.36              | -0.57                     | 0.71    | -0.12   | 0.00             | 0.73                     |
| 0.26    | 0.54 | 0.07        | -0.36      | 0.10               | -0.34              | -0.55                     | 0.71    | -0.11   | 0.00             | 0.71                     |
| 0.27    | 0.53 | 0.10        | -0.34      | 0.08               | -0.33              | -0.54                     | 0.70    | -0.11   | 0.00             | 0.68                     |
| 0.26    | 0.52 | 0.11        | -0.32      | 0.07               | -0.32              | -0.52                     | 0.69    | -0.11   | 0.00             | 0.66                     |
| 0.26    | 0.51 | 0.12        | -0.31      | 0.06               | -0.31              | -0.51                     | 0.68    | -0.10   | 0.00             | 0.63                     |
| 0.25    | 0.50 | 0.12        | -0.30      | 0.06               | -0.30              | -0.49                     | 0.65    | -0.10   | 0.00             | 0.61                     |
| 0.25    | 0.48 | 0.11        | -0.29      | 0.06               | -0.29              | -0.48                     | 0.63    | -0.10   | 0.00             | 0.59                     |
| 0.24    | 0.47 | 0.09        | -0.28      | 0.06               | -0.28              | -0.46                     | 0.60    | -0.09   | 0.00             | 0.56                     |
| 0.23    | 0.45 | 0.08        | -0.27      | 0.06               | -0.27              | -0.44                     | 0.57    | -0.09   | 0.00             | 0.54                     |
| 0.22    | 0.43 | 0.06        | -0.26      | 0.06               | -0.26              | -0.43                     | 0.54    | -0.09   | 0.00             | 0.52                     |
| 0.21    | 0.42 | 0.04        | -0.25      | 0.06               | -0.25              | -0.41                     | 0.51    | -0.08   | 0.00             | 0.50                     |

Figure 10:  Fall in Labor tax rate (alternative calibrations)

Data for Figure 10
| Quarter | Benchmark: Real GDP | Benchmark: Real Exchange Rate | Benchmark: Private Absorption | Benchmark: Trade Balance /GDP | All house- holds optimize: Real GDP | All house- holds optimize: Real Exchange Rate | All house- holds optimize: Private Absorption | All house- holds optimize: Trade Balance /GDP | High labor supply elas: Real GDP | High labor supply elas: Real Exchange Rate | High labor supply elas: Private Absorption | High labor supply elas: Trade Balance /GDP |
|---------|---------------------|-------------------------------|-------------------------------|-------------------------------|-------------------------------------|-----------------------------------------------|-----------------------------------------------|-----------------------------------------------|----------------------------------|--------------------------------------------|--------------------------------------------|--------------------------------------------|
| 0.73    | -0.94               | 0.84                          | -0.12                         | 0.03                          | 0.07                                | 0.03                                          | 0.00                                          | 0.81                                          | -0.73                            | 0.92                                       | -0.11                                      |
| 0.56    | -0.93               | 0.70                          | -0.06                         | 0.05                          | 0.07                                | 0.04                                          | 0.00                                          | 0.71                                          | -0.69                            | 0.84                                       | -0.06                                      |
| 0.43    | -0.88               | 0.60                          | -0.02                         | 0.07                          | 0.08                                | 0.06                                          | 0.00                                          | 0.64                                          | -0.61                            | 0.79                                       | -0.04                                      |
| 0.34    | -0.79               | 0.52                          | -0.02                         | 0.09                          | 0.09                                | 0.08                                          | 0.00                                          | 0.62                                          | -0.48                            | 0.77                                       | -0.04                                      |
| 0.29    | -0.67               | 0.48                          | -0.04                         | 0.11                          | 0.11                                | 0.09                                          | 0.00                                          | 0.62                                          | -0.30                            | 0.78                                       | -0.07                                      |
| 0.26    | -0.58               | 0.45                          | -0.07                         | 0.13                          | 0.13                                | 0.11                                          | 0.00                                          | 0.65                                          | -0.16                            | 0.81                                       | -0.10                                      |
| 0.25    | -0.51               | 0.44                          | -0.09                         | 0.14                          | 0.15                                | 0.13                                          | -0.01                                         | 0.70                                          | -0.04                            | 0.86                                       | -0.13                                      |
| 0.25    | -0.46               | 0.44                          | -0.11                         | 0.16                          | 0.17                                | 0.14                                          | -0.01                                         | 0.74                                          | 0.05                             | 0.90                                       | -0.14                                      |
| 0.25    | -0.42               | 0.44                          | -0.11                         | 0.17                          | 0.18                                | 0.16                                          | -0.01                                         | 0.79                                          | 0.12                             | 0.95                                       | -0.15                                      |
| 0.26    | -0.38               | 0.45                          | -0.12                         | 0.19                          | 0.20                                | 0.17                                          | -0.01                                         | 0.82                                          | 0.16                             | 0.98                                       | -0.15                                      |
| 0.26    | -0.36               | 0.45                          | -0.11                         | 0.20                          | 0.20                                | 0.18                                          | -0.01                                         | 0.85                                          | 0.19                             | 1.00                                       | -0.15                                      |
| 0.27    | -0.34               | 0.45                          | -0.11                         | 0.21                          | 0.21                                | 0.19                                          | -0.01                                         | 0.86                                          | 0.20                             | 1.01                                       | -0.15                                      |
| 0.26    | -0.32               | 0.44                          | -0.11                         | 0.21                          | 0.21                                | 0.19                                          | -0.01                                         | 0.86                                          | 0.20                             | 1.00                                       | -0.14                                      |
| 0.26    | -0.31               | 0.43                          | -0.10                         | 0.21                          | 0.21                                | 0.19                                          | -0.01                                         | 0.85                                          | 0.20                             | 0.98                                       | -0.13                                      |
| 0.25    | -0.30               | 0.42                          | -0.10                         | 0.21                          | 0.21                                | 0.19                                          | -0.01                                         | 0.83                                          | 0.19                             | 0.96                                       | -0.12                                      |
| 0.25    | -0.29               | 0.41                          | -0.10                         | 0.21                          | 0.20                                | 0.19                                          | -0.01                                         | 0.81                                          | 0.18                             | 0.92                                       | -0.11                                      |
| 0.24    | -0.28               | 0.39                          | -0.09                         | 0.21                          | 0.20                                | 0.19                                          | 0.00                                          | 0.78                                          | 0.17                             | 0.88                                       | -0.10                                      |
| 0.23    | -0.27               | 0.38                          | -0.09                         | 0.21                          | 0.19                                | 0.18                                          | 0.00                                          | 0.75                                          | 0.17                             | 0.84                                       | -0.09                                      |
| 0.22    | -0.26               | 0.36                          | -0.09                         | 0.20                          | 0.19                                | 0.18                                          | 0.00                                          | 0.72                                          | 0.16                             | 0.80                                       | -0.08                                      |
| 0.21    | -0.25               | 0.34                          | -0.08                         | 0.20                          | 0.18                                | 0.17                                          | 0.00                                          | 0.69                                          | 0.16                             | 0.75                                       | -0.07                                      |

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# Footnotes

*   We thank MatthieuBussière and Paolo Pesenti as well as seminar participantsat the Federal Reserve Board, George Washington University, theCouncil on Foreign Relations, and the International Monetary Fund.The views expressed in this paper are solely the responsibility ofthe authors and should not be interpreted as reflecting the viewsof the Board of Governors of the Federal Reserve System or of anyother person associated with the Federal ReserveSystem. Corresponding Author: Luca Guerrieri, Telephone 202-452-2550, Fax 202-872-4926.Email addresses: [email protected], [email protected],and [email protected]. Return totext

1.   Here we limit our attention to twocountries, and focus exclusively on tax shocks. For a more detaileddiscussion of the SIGMA model and its properties, see Erceg,Guerrieri, and Gust (2004). Return totext

2.   In the paper, we compare our model'simplications with those of the FRB/Global model, a workhorse modelused for policy simulations at the Federal Reserve. Return to text

3.   In alternative calibrations of SIGMA,we also consider the specification used by Yun (1995) and Erceg,Henderson, and Levin (2000) where  so that  in the profit functionaldefined below; similarly, prices are updated according to  in foreignmarkets. Given this form of static indexing, the price-settingequation is purely forward-looking, so that there is no intrinsicinflation inertia. Return to text

4.   We define  to be the price in period of a claim that pays one dollar if thespecified state occurs in period  (see thehousehold problem below); then the corresponding element of  equals  divided by the probability thatthe specified state will occur. Return totext

5.   Mankiw (2000) stresses the importanceof including rule of thumb behavior in models for analyzing fiscalpolicy. Mankiw cites estimates suggesting that consumptionsmoothing is far from perfect and that many households have networth near zero. Galí, López-Salido, andVallés also incorporate rule-of-thumb households into theirmodel to account for a rise in aggregate consumption in response toa government spending shock. Return totext

6.   This intermediation cost isasymmetric, as foreign households do not face these costs. Rather,they collect profits on the monopoly rents associated with theseintermediation costs. The intermediation costs depend on the ratioof economy-wide holdings of net foreign assets to nominal outputand are given by: . Return to text

7.   We could assume instead thatgovernment purchases enter separably in the utility function. Thiswould not alter the model's equilibrium outcome but would havedifferent welfare consequences. Return totext

8.   We evaluated the robustness of oursolution procedure by using a nonlinear Newton-Raphson algorithmthat does not rely on linearization around an initial steady state,and found that the results were nearly identical to thosereported. Return to text

9.   Our calibrated share is on the highrange of estimates surveyed by Weber (2002). As indicated below, asmaller share would imply that fiscal deficits induce an evensmaller deterioration in the trade balance than under our benchmarkparameterization. Return to text

10.   The rapid adjustment of import pricesis consistent with the evidence Campa and Goldberg (2004) derivedfrom a panel of OECD countries, nothwithstanding their finding thatlong-run passthrough is generally well below 100 percent for OECDcountries. Return to text

11.   While it is unsurprising that thevast empirical literature estimating trade price elasticities hasreported a range of estimates, the level of aggregation used inestimation seems of crucial importance. Estimates of the long-runelasticity derived from aggregate data are typically in the rangeof unity, e.g., Hooper and Marquez (1995), with the estimate of animport price elasticity of 3.5 of Erkel, Rousse, and Mirza (2004) aclear outlier. By contrast, estimates using disaggregated data arefrequently in the range of 3 or even higher; see Obstfeld andRogoff (2001) for a concise review or McDaniel and Balistreri(2003) for a more detailed survey. Return to text

12.   Hooper, Johnson and Marquez (2000)find that the short-run elasticity is significantly smaller thanthe long-run elasticity in their study using macroeconomic data.This is qualitatively consistent with the results of industrystudies as surveyed by McDaniel and Balistreri(2003). Return to text

13.   We estimated the rule usinginstrumental variables with lags of inflation and output growth asinstruments. Return to text

14.   The deficit-to-GDP ratio rises byless than 1 percentage point due to an endogenous rise ingovernment receipts from taxes on labor and capitalincome. Return to text

15.   The effect of the change in theexchange rate on import and export prices is muted initially givenour assumption of local currency pricing; however, exchange ratepassthrough is nearly complete after a few quarters. Return to text

16.   Given that exports fall 1-1/2 percentand the steady state export/GDP ratio is 0.12, the partial effecton the nominal trade/GDP ratio is a 0.18 percentage pointdecline. Return to text

17.   Because we assume adjustment costson investment, the national accounts identity in equation (24) only holds to afirst-order approximation in our model. Return to text

18.   As noted in the calibration section,this choice of a long-run trade price elasticity is at the upperbound of estimates derived from macro data. Return to text

19.   However, this effect is partiallyoffset by the effect of higher real rates on private domesticabsorption, as the policy rule acts to choke off higher growth innominal demand. Return to text

20.   In a DGE model that assumes allhouseholds are optimizers, Müller (2004) shows that a lowerimport price elasticity of substitution than used here could evenlead to an improvement in the trade balance following a rise ingovernment spending. Under these conditions, our model could alsogenerate an improvement. Return totext

21.   The Taylor rule we used has acoefficient of 1.5 on the four-quarter change in domestic inflationand 0.5 on the output gap, where potential output is determined byholding employment at its steady state level. Return to text

22.   We verified that the implications forthe trade deficit reported below would be virtually unaffected ifwe assumed instead that the endogenous tax adjustment occurredthrough a gradual increase in labor tax rates. Return to text

23.   The positive supply side effects ofthe labor tax cut dampen the magnitude of the real interest rateincrease, and also cause the real exchange rate to depreciate inthe longer-term; given the uncovered interest parity condition,these effects serve to dampen the initial appreciation relative tothe case of the goverment spending shock. Return to text

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