## wp18226

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### Introduction — macroeconomic context and motivation
- Hydrocarbon exports represent more than half of total exports for Gulf countries.
- Oil revenues account for 80 percent of total fiscal revenues, on average, and about 20 percent of GDP.
- Projected prices for oil fall below fiscal breakeven prices in the medium-term for most countries.
- Financial sectors in many oil-exporting countries have grown fairly large; macro-financial linkages can exacerbate oil price shocks and create systemic financial sector vulnerabilities that can adversely affect the real economy.
- Governments in oil-exporting developing countries frequently conduct procyclical fiscal policies because of:
  - the budget structure,
  - inability to smooth spending due to lack of pertinent financial instruments,
  - limited access to credit markets,
  - political and institutional constraints.
- Government investment expenditure and current spending drive non-oil GDP growth in most oil-dependent countries, implying oil price fluctuations determine the business cycle absent economic diversification.

### Analytical contribution and model structure
- Micro-founded DSGE model incorporates:
  - an active banking sector including an interbank market,
  - an oil-producing sector,
  - a national development fund collecting a share of oil revenue,
  - a fiscal regime that depends on the fund and oil revenues,
  - government provision of productive capital to intermediate goods producers (to capture SOE involvement).
- Model assumptions and abstractions:
  - The economy is modeled as an autarky and abstracts from exchange rate regimes.
  - Oil revenue windfalls are incorporated; the national development fund acts as both saving and stabilization fund to hedge banking system liquidity risk.
  - Model includes traditional real sectors plus the oil sector and a heterogeneous banking system (deposit banks and lending banks).
- Scope: examines interactions among macro aggregates, the financial sector, and channels linking business and financial cycles in oil economies.

### Key mechanisms and transmission channels
- Fiscal channel:
  - Positive oil shocks boost fiscal revenues and fiscal space, enabling expanded social transfers to households and increased public capital expenditure.
  - Government fiscal regime in the model is highly procyclical.
  - National development fund finances parts of government expenditure and the banking sector’s needs.
- Banking and interbank channel:
  - Banks: commercial loans to firms, purchase government bonds, finance partly via interbank market and partly from the national development fund.
  - Endogenous interbank rate depends on deposit supply, which in turn relies on government transfers to households.
  - Deposit banks: monopolistically competitive, offer one-period deposit instruments, face quadratic adjustment costs on deposit rates.
  - Lending banks: provide one-period loan contracts to goods producers and the government; finance via interbank borrowing, central bank lending, and national development fund resources; face quadratic adjustment costs on raising loans.
  - Liquidity shortages or surpluses alter the interbank rate relative to the policy rate.
- Real economy and labor channel:
  - Complementarities between oil and non-oil sectors make labor allocation central to propagation of oil-sector technology shocks and oil price shocks.
  - Fixed labor supply dampens shock impacts on consumption and GDP and prevents wages and prices from fully acting as automatic stabilizers.
- Financial amplification channels (three principal routes):
  1. Government investment falls after oil revenue declines → halted SOE projects and private-contractor failures → higher bank NPLs from direct SOE exposure and private-sector project failures → reduced credit availability.
  2. Public sector wage bill containment → lower household disposable income, consumption, and bank deposits → higher household financial fragility → higher NPLs and deposit volatility → increased banks’ liquidity-management costs and central bank borrowing reliance.
  3. Slower non-oil GDP growth → depressed stock and housing markets → higher bank credit risk and lower credit-to-economy outcomes; longer-run effects: lower international reserves accumulation and capital outflow.

### Model agents and market completeness
- Large-scale small open economy specification with eight types of agents and explicit macro-financial links.
- Households:
  - Lifetime utility U(Ct, Nt) = Ct^(1−σ)/(1−σ) − χ_N Nt^(1+φ)/(1+φ).
  - Budget constraint Ct + Dt+1 + Tt ≤ Wt Nt + R^D_t D_t Π_{t+1} + Γ_t + P.
  - Euler condition: 1/R^D_{t+1} = β E_t(1/Π_{t+1} (C_{t+1}/C_t)^{−σ}).
- Firms and production:
  - Final-good producers aggregate intermediate goods with elasticity of substitution θ.
  - Intermediate goods producers: Cobb-Douglas technology with private and public capital, Calvo nominal price rigidity with indexation parameter χ ∈ [0,1], fraction 1−α_p unable to change prices each period.
  - Capital producers: investment adjustment costs Φ(i_t / i_{t−1}) = 1 − ξ/2 (i_t / i_{t−1} − 1)^2 (i_t / i_{t−1}); capital price P^k_t (Tobin’s Q).
- Oil sector:
  - Government-owned; Cobb-Douglas production using capital and labor; oil output Y^o sold abroad at price P^o.
  - Capital law: K^o_t = (1−δ_o) K^o_{t−1} + α_o P^o_t Y^o_t.
  - Oil price AR(1): P^o_t = ρ_o P^o_{t−1} + (1−ρ_o) P^o + ε^o_t, with ε^o_t ∼ i.i.d.(0, σ^2_o).
- Financial sector specifics:
  - Deposit banks: D_t(i) = (R^D_t(i) / R^D_t)^ε D_t; Rotemberg-type quadratic adjustment costs; first-order condition links deposit rate to interbank rate and adjustment costs.
  - Lending banks: aggregate balance sheet B_{t+1} + L_t = D_{t+1} + B^{CB}_t + ω_t; net worth dynamics include quadratic penalties η_B, η_D, η_L; first-order conditions pin R^{IB}_t, R^B_t, R^k_t to the policy rate with markups/markdowns.
  - Lending banks have unlimited access to national development fund resources at the policy rate after exhausting other resources; hence policy rate pins other rates.

### Main results and implications (qualitative)
- Fiscal regime crucial: positive oil shocks raise consumption and public investment; higher public investment raises non-oil output and the fiscal multiplier.
- Labor market complementarities with oil sector make labor allocation a key transmission channel; fixed labor supply limits automatic stabilization via wages/prices.
- Banks amplify oil-price-driven shocks even if not primary direct propagation channel (oil sector not directly bank-exposed; model abstracts from credit default).
- Heterogeneous banking system creates differentiation in market interest rates across households, government, non-oil firms, the national development fund, and the central bank, contributing to amplification and transmission.

### Policy considerations highlighted by the model
- National development fund roles:
  - Acts as both a saving fund and a stabilization fund to hedge banking system liquidity risk and support lending banks when other resources are exhausted.
- Financial-market development:
  - Developing the interbank market reduces reliance on central bank emergency lending at premium rates and mitigates banks’ liquidity-management costs.
- Fiscal policy design:
  - Smoothing mechanisms and countercyclical fiscal policy (versus the model’s procyclical outcome) could reduce transmission of oil-price volatility to the real economy and financial sector.
- Monetary policy:
  - Inflation-targeting monetary policy is incorporated (central bank follows a Taylor rule), allowing study of monetary shocks under inflation targeting in the oil-exporter context.

### Government — budget, transfers, and institutional interactions
- Government budget constraint (equation (37)):
  - T_t + B_{t+1} + νΘ_t + (ρ_g + R^*_t)F_{t−1} = G_t + R^B_t B_t + Γ_t
- Tax and transfer rules:
  - T_t = τ_d (R^D_{t−1}) D_t + τ_c C_t + τ_w W_t N_t + τ_k P  (equation (38))
  - Γ_t = ρ_Γ ν Θ_t  (equation (39))
- Government expenditure composition:
  - G^c_t = G^c  (equation (40)) — government current expenditure assumed constant
  - G^p_t = K^G_t − (1−σ_G) K^G_{t−1} = G^p  (equation (41)) — government investment in public capital
  - G_t = G^c_t + G^p_t  (equation (42))
- Parameters and access:
  - τ_d, τ_c, τ_w, τ_k are tax rates on return on deposits, consumption, wage and profits.
  - Government sets transfers according to oil revenue by parameter ρ_Γ.
  - Government access: fraction ν of oil revenue Θ_t and fraction ρ_g of national development fund F_t; oil fund earns international return R^*_t.
- Central bank policy rule (Taylor rule) (equation (43)):
  - r^{CB}_t = ρ_{cb} r^{CB}_{t−1} + (1−ρ_{cb})( r^{CB} + ρ_π (Π_t − Π) + ρ_y (Y_t − Y) )
  - Y is GDP and 1 + r^{CB}_t = R^{CB}_t.
- National development fund dynamics (equation (44)):
  - F_t = (1−ρ_g) F_{t−1} + (1−ν) Θ_t + R^{CB}_{t−1} B^{CB}_{t−1} − B^{CB}_t
- Market clearing relations (selected):
  - GDP_t + R^*_t F_{t−1} = C_t + Φ(i_t, i_{t−1}) i_t + α_o P^o_t Y^o_t + G_t + (F_t − F_{t−1})  (equation (45))
  - N_t = N^o_t + N^n_t  (equation (46))
  - P = Π_K_t + Π_R_t + Π_D_t + Π_L_t  (equation (47))
  - GDP_t = Y^H_t + P^o_t Y^o_t

### Results — model calibration, shocks, and propagation mechanisms
- Calibration and setup:
  - Model calibrated to quarterly data for Iran’s economy from 1985-2015.
  - Model abstracts from exchange rate and external sector.
- Shock specifications:
  - Oil price and technology shocks stationary and follow AR(1):
    - P^o_t = (1−ρ_o) P^o + ρ_o P^o_{t−1} + ε^o_t
    - log(A_t) = ρ_i log(A_{t−1}) + ε^a_t
    - ε^i ~ N(0, σ^2_i), i = P^o, A.

### Technology shocks (non-oil and oil-sector TFP)
- Non-oil one-standard-deviation positive TFP shock:
  - Increases non-oil output, wages, and labor employed.
  - Reduces oil production and revenues via labor reallocation when oil price unchanged.
  - Transfers diminish for a few periods as government oil revenues fall and households get wealthier.
  - Marginal cost falls on impact → inflation declines → central bank cuts policy rate → market rates fall.
  - Decline in rates reduces banking system net worth, deposit and government bond supply.
  - Loan demand falls as firms decrease capital accumulation.
- Scenario parameter cases:
  - No price stickiness: α_p = 0.
  - Higher oil-sector capital replacement cost: α_o = 0.1.
  - No Rotemberg adjustment cost in deposit bank: κ_D = 0.
  - No market power for deposit banks: ε_D = ∞.
  - Near perfect pass-through of rates through lending banks: η_D, η_B, η_L ≃ 0.
- Comparison findings:
  - Higher α_o slightly dampens technology shock impact.
  - Absence of price stickiness materially alters monetary policy behavior.
  - Removing sticky rates and imperfect competition marginally changes results.
  - Quasi-perfect pass-through amplifies expansion following technology shock; deposit and interbank rates remain determined by deposit banks with monopolistic power.
- Oil-sector TFP shock of exactly "1 percent":
  - Same directional effects but more pronounced.
  - Increases oil revenues and transfers, prompting higher public investment and public capital accumulation.
  - On impact marginally reduces marginal cost and inflation → monetary policy reduces policy rate.

### Oil price shocks
- One-standard-deviation positive oil price shock:
  - Boosts oil revenue → increases oil-sector investment and capital stock → amplifies oil production and total output.
  - Induces higher labor demand in oil sector → interpreted as labor supply shock for non-oil sector → pushes up wages and non-oil prices initially.
  - Monetary policy initially raises policy rate in response to positive output and price gaps; subsequently central bank cuts as dynamics evolve.
  - Rising oil revenues reduce government bond issuance and tax dependence; transfers increase leading households to work less and raise consumption.
  - Lower market rates lead non-oil firms to substitute labor with capital → capital stock rises.
  - Oil fund initially overshoots due to revenues but subsequently injects resources into banking system as deposits fall and loan demand rises; central bank lending complements injections until steady state resumes.
  - Interbank rate adjustment rigidity leads to an interbank rate increase smaller than central bank rate increase; lending banks prefer interbank borrowing.
- Scenario comparisons:
  - No Calvo pricing (α_p = 0): retailers adjust prices instantly → dampens shock impact on variables; non-oil sector cannot raise prices → output falls and capital accumulation increases; government initially issues higher bonds to support transfers and public investment.
  - Higher oil re-investment: GDP and consumption expand more; convergence to steady state slower; oil sector greedier for labor → non-oil output declines faster and more protractedly; monetary reaction remains protracted and rates stay low longer.

### Role of banking sector and financial frictions
- Model purpose: introduce national development fund and link to banking sector and government; analyze interbank market effects and differentiated market rates.
- Findings on financial frictions:
  - Deposit bank monopolization or deposit rate adjustment cost has mild impact.
  - Lending bank adjustment costs are critical:
    - Removing lending-bank adjustment costs (instantaneous rate changes) leads non-oil firms to substitute labor with capital earlier → initial labor demand falls and investment soars.
    - Price index falls → central bank cuts policy rate → investment further boosts; after two quarters non-oil output rises and labor overshoots.
    - Consumption declines initially but rises as transfers and labor rebound; cumulative GDP impact higher than benchmark in this scenario.
  - Sensitivity: results very sensitive to parameter calibration (household labor utility, Taylor rule).

### Concluding remarks — policy implications and limitations
- Main qualitative results:
  - Labor market complementarities across oil and non-oil sectors make labor allocation a key channel for shock spillovers.
  - Wage and price stabilization policies help prevent large swings of production factors between sectors and stabilize monetary policy behavior.
  - Government role: higher oil revenues magnify transfers and public capital expenditure, increase consumption, affect labor supply, and enhance fiscal multipliers through public capital used in non-oil output.
  - Banks amplify but do not fundamentally drive oil shock propagation; lending-bank frictions matter more than deposit-bank market power.
- Policy-relevant takeaways:
  - Stabilizing wages and prices can act as automatic stabilizers across sectors.
  - Managing government use of oil revenues (transfers versus public investment) critically affects non-oil sector outcomes and fiscal multipliers.
  - Financial-sector design that reduces lending-rate rigidities can materially change transmission from oil shocks to the real economy.
- Limitations and extensions:
  - Sensitivity to labor market specification; real-world oil sector is capital intensive with specialized labor and low substitutability.
  - Absence of exchange rate and trade; a small open economy with a real exchange rate could exacerbate Dutch disease effects.
  - Introducing credit-constrained firms, collaterals, and default would embed a financial accelerator and make banking central to shock propagation.
  - Incorporating an exchange-rate stabilization objective and an intervention rule for the central bank could improve dynamics for many oil-exporting countries.

### Appendix — calibrated parameters (quarterly)
- Discount factors: β 0.9595, R_D = 0.18(annually)
- Consumption elasticity σ 1.5 (Bhattacharjee et al.(2007))
- Relative utility weight of labor χ_N 0.52, N = 1
- Inverse Frisch elasticity of labor supply φ 2.17 (Motevaseli et al.(2011))
- Elasticity of private capital γ_n 0.30, K/GDP = 2
- Elasticity of public capital γ_G 0.1 (Berg et al.(2013))
- Elasticity of private capital in oil γ_o 0.80, K_o/GDP = 0.30
- Coef. of intermediate producer θ, χ, α_p 9, 0.241, 0.503; 0% Mark up (Daliri and Mehrgan(2015))
- Depreciation rates δ_k, δ_o, δ_g 0.05, 0.007, 0.1 (Motevaseli et al.(2011))
- Capital Pro. adj. cost ξ 2 (Daliri and Mehrgan(2015))
- Coef. of deposit bank ε, κ_D 237, 1.5, R_IB = 0.20(annually)
- Taxes τ_c, τ_d, τ_w, τ_k 0.09, 0, 0.04, 0.15 (Average tax rates)
- Central bank ρ_cb, ρ_π, ρ_y 0.10, 1.5, 0.125 (Gertler and Karadi(2011))
- Oil AR processes ρ_o 0.80 (Guerra-Salas(2014))
- Other AR processes ρ_A, ρ_Ao, ρ_ξ 0.80, 0.90, 0.90
- Gov. share of oil revenue ν 0.70
- Gov usage of oil fund ρ_g 0.05
- Share of Transfer in Oil Rev. ρ_Γ 0.33
- Share of investment in oil revenue α_o 0.01
- Adj. costs of lending bank η_D, η_B, η_L 2, 0.2, 2

### Appendix — steady state of the benchmark model (quarter)
- Consumption C 0.64 (Steady State/GDP)
- Transfer Γ 0.05
- Private capital K 2
- Oil capital K_o 0.36
- Public capital K_G 0.48
- Non-oil output P_H Y_H 0.75
- Oil revenue P_o Y_o 0.25
- Gov. expenditure G_c, G_p, G 0.25, 0.046, 0.30
- Investment X 0.10
- Gov. loans B 0.40
- Tax T 0.09
- Total government’s budget 0.78
- Current expenditure/investment G_c/G_p 5.5

### Figures and captions (selected)
- Figure 1: Oil Revenue to export — country bars including United Arab Emirates, Bahrain, Iran, Qatar, Oman, Saudi Arabia, Kuwait, Iraq.
- Figure 2: Oil Revenue to GDP — country bars including Iran, United Arab Emirates, Bahrain, Qatar, Saudi Arabia, Oman, Iraq, Kuwait.
- Figure 3: IMF fiscal breakeven price.
- Figure 4: Market Capitalization/GDP - 2017 — country bars including Kazakhstan, Oman, Bahrain, Saudi Arabia, United Arab Emirates, Kuwait, Qatar.
- Figure 5: Public Investment/GDP - 2017.
- Figure 6: Private Investment/GDP - 2017.
- Figures 7–11: Impulse-response plots — percentage change from the steady state for key variables across 0–20 Quarters under various 1% standard deviation positive shocks.

*Source: wp18226 - 2.7 Government (PDF chapter/section).*

### References25

### References25

### Introduction — macroeconomic context and motivation
- Hydrocarbon exports represent more than half of total exports for Gulf countries.
- Oil revenues account for 80 percent of total fiscal revenues, on average, and about 20 percent of GDP.
- Projected prices for oil fall below fiscal breakeven prices in the medium-term for most countries.
- Financial sectors in many oil-exporting countries have grown fairly large; macro-financial linkages can exacerbate oil price shocks and create systemic financial sector vulnerabilities that can adversely affect the real economy.
- Governments in oil-exporting developing countries frequently conduct procyclical fiscal policies because of:
  - the budget structure,
  - inability to smooth spending due to lack of pertinent financial instruments,
  - limited access to credit markets,
  - political and institutional constraints.
- Government investment expenditure and current spending drive non-oil GDP growth in most oil-dependent countries, implying oil price fluctuations determine the business cycle absent economic diversification.

### Analytical contribution and model structure
- The paper proposes a micro-founded DSGE model that incorporates:
  - an active banking sector including an interbank market,
  - an oil-producing sector,
  - a national development fund collecting a share of oil revenue,
  - a fiscal regime that depends on the fund and oil revenues,
  - government provision of productive capital to intermediate goods producers (to capture SOE involvement).
- Model assumptions and abstractions:
  - The economy is modeled as an autarky and abstracts from exchange rate regimes.
  - Oil revenue windfalls are incorporated; the national development fund acts as both saving and stabilization fund to hedge banking system liquidity risk.
  - The model includes traditional real sectors plus the oil sector and a heterogeneous banking system (deposit banks and lending banks).
- Scope: the model examines how macroeconomic aggregates, the financial sector, and channels linking business and financial cycles interact in oil economies — a nexus less explored in existing literature.

### Key mechanisms and transmission channels
- Fiscal channel:
  - Positive oil shocks boost fiscal revenues and fiscal space, enabling expanded social transfers to households and increased public capital expenditure.
  - Government fiscal regime in the model is highly procyclical (consistent with Tazhibayeva et al.(2008), Murphy et al.(2010)).
  - The national development fund finances parts of government expenditure and the banking sector’s needs.
- Banking and interbank channel:
  - Banks give commercial loans to firms, purchase government bonds, and finance operations partly by borrowing through the interbank market and partly from the national development fund.
  - The endogenous interbank rate depends on the supply of deposits, which in turn relies on government transfers to households.
  - Deposit banks are monopolistically competitive, offer one-period deposit instruments to households, and lend to lending banks at the interbank rate; they face quadratic adjustment costs on deposit rates.
  - Lending banks provide one-period loan contracts to goods producers and the government, finance via interbank borrowing, central bank lending, and national development fund resources, and face quadratic adjustment costs on raising loans.
  - Liquidity shortages or surpluses alter the interbank rate relative to the policy rate (interbank rate can fall below or rise above the policy rate).
- Real economy and labor channel:
  - Complementarities between oil and non-oil sectors make the labor market an important driver of shock diffusion; fixed labor supply makes labor allocation central to propagation of oil-sector technology shocks and oil price shocks.
  - This labor-channel dampens shock impacts on consumption and GDP and prevents wages and prices from fully acting as automatic stabilizers.
- Financial amplification channels (three principal routes highlighted):
  1. Government investment falls after oil revenue declines; SOEs and their contractors (private firms) face halted projects and failures, raising banks’ nonperforming loans (NPLs) both from direct SOE exposure and from private-sector project failures, reducing credit availability.
  2. Public sector wage bill containment reduces household disposable income, consumption, and bank deposits; higher household financial fragility raises NPLs and deposit volatility, increasing banks’ liquidity management costs and reliance on central bank borrowing at a premium in absence of a developed interbank market.
  3. Slower non-oil GDP growth depresses stock and housing markets; banks’ exposure to these markets raises credit risk and lowers credit-to-economy outcomes; longer-run channels include lower international reserves accumulation and capital outflow.

### Model agents and market completeness
- The DSGE model is a large-scale small open economy specification with eight types of agents including explicit macro-financial links.
- Households:
  - Maximize lifetime utility with single-period utility U(Ct, Nt) = Ct^(1−σ)/(1−σ) − χ_N Nt^(1+φ)/(1+φ), subject to budget constraint Ct + Dt+1 + Tt ≤ Wt Nt + R^D_t D_t Π_{t+1} + Γ_t + P.
  - First-order conditions include Euler condition 1/R^D_{t+1} = β E_t(1/Π_{t+1} (C_{t+1}/C_t)^{−σ}).
- Firms and production:
  - Final-good producers aggregate intermediate goods with elasticity of substitution θ.
  - Intermediate goods producers use Cobb-Douglas technology with private and public capital, face Calvo nominal price rigidity with indexation parameter χ ∈ [0,1], and a fraction 1−α_p unable to change prices each period.
  - Capital producers face investment adjustment costs Φ(i_t / i_{t−1}) = 1 − ξ/2 (i_t / i_{t−1} − 1)^2 (i_t / i_{t−1}) and produce capital sold at price P^k_t (Tobin’s Q).
- Oil sector:
  - Government-owned; Cobb-Douglas production using capital and labor; oil output Y^o sold abroad at price P^o.
  - Capital in oil sector evolves K^o_t = (1−δ_o) K^o_{t−1} + α_o P^o_t Y^o_t.
  - Oil price follows AR(1): P^o_t = ρ_o P^o_{t−1} + (1−ρ_o) P^o + ε^o_t, with ε^o_t ∼ i.i.d.(0, σ^2_o).
- Financial sector specifics:
  - Deposit banks: face Dixit-Stiglitz deposit demand D_t(i) = (R^D_t(i) / R^D_t)^ε D_t, maximize profits with Rotemberg-type quadratic adjustment costs; first-order condition links deposit rate to interbank rate and adjustment costs (equation 31).
  - Lending banks: aggregate balance sheet B_{t+1} + L_t = D_{t+1} + B^{CB}_t + ω_t; net worth dynamics include quadratic penalties η_B, η_D, η_L; first-order conditions pin R^{IB}_t, R^B_t, R^k_t to the policy rate with markups/markdowns (equations 34–36).
  - Lending banks have unlimited access to national development fund resources at the policy rate after exhausting other resources; hence policy rate pins other rates in the financial system through these equations.

### Main results (qualitative) and implications
- Government fiscal regime is crucial in propagation of shocks: positive oil shocks raise consumption and public investment; higher public investment raises non-oil output and the fiscal multiplier.
- Labor market complementarities with oil sector make labor allocation a key transmission channel; fixed labor supply limits automatic stabilization via wages/prices.
- Banks amplify oil-price-driven shocks even if they are not the primary direct propagation channel (because oil sector is not directly bank-exposed and the model abstracts from credit default).
- Heterogeneous banking system (deposit vs. lending banks) creates differentiation in market interest rates across households, government, non-oil firms, the national development fund, and the central bank, contributing to amplification and transmission of shocks.

### Policy considerations highlighted by the model
- The national development fund can act as both a saving fund and a stabilization fund to hedge banking system liquidity risk and support lending banks when other resources are exhausted.
- Developing the interbank market reduces reliance on central bank emergency lending at premium rates and mitigates liquidity-management costs for banks.
- Fiscal policy design matters: smoothing mechanisms and countercyclical fiscal policy (versus the model’s procyclical outcome) could reduce transmission of oil-price volatility to the real economy and financial sector.
- Inflation-targeting monetary policy is incorporated in the model (central bank follows a Taylor rule), allowing study of monetary shocks under inflation targeting in the oil-exporter context.

*Source: wp18226 - References25 (IMF working paper content provided).*

### 2.7    Government

### 2.7 Government

### Government budget, transfers, and expenditure rules
- Government budget constraint (equation (37)):
  - T_t + B_{t+1} + νΘ_t + (ρ_g + R^*_t)F_{t−1} = G_t + R^B_t B_t + Γ_t
- Tax and transfer rules:
  - T_t = τ_d (R^D_{t−1}) D_t + τ_c C_t + τ_w W_t N_t + τ_k P  (equation (38))
  - Γ_t = ρ_Γ ν Θ_t  (equation (39))
- Government expenditure composition and dynamics:
  - G^c_t = G^c  (equation (40)) — government current expenditure assumed constant
  - G^p_t = K^G_t − (1−σ_G) K^G_{t−1} = G^p  (equation (41)) — government investment in public capital
  - G_t = G^c_t + G^p_t  (equation (42)) — total government expenditure
- Definitions and parameters:
  - τ_d, τ_c, τ_w, τ_k are tax rates on return on deposits, consumption, wage and profits, respectively.
  - Government sets transfers according to oil revenue by parameter ρ_Γ.
  - Government has access to fraction ν of oil revenue Θ_t and fraction ρ_g of national development fund F_t; the oil fund earns international return R^*_t.

### Central bank and national development fund interaction
- Central bank policy rule (Taylor rule) (equation (43)):
  - r^{CB}_t = ρ_{cb} r^{CB}_{t−1} + (1−ρ_{cb})( r^{CB} + ρ_π (Π_t − Π) + ρ_y (Y_t − Y) )
  - Y is GDP and 1 + r^{CB}_t = R^{CB}_t.
- National development fund dynamics (equation (44)):
  - F_t = (1−ρ_g) F_{t−1} + (1−ν) Θ_t + R^{CB}_{t−1} B^{CB}_{t−1} − B^{CB}_t
  - The fund receives a share of oil revenues, experiences depreciation, and interacts with central bank lending and deposits.

### Market clearing conditions
- Aggregate and market clearing relations:
  - GDP_t + R^*_t F_{t−1} = C_t + Φ(i_t, i_{t−1}) i_t + α_o P^o_t Y^o_t + G_t + (F_t − F_{t−1})  (equation (45))
  - N_t = N^o_t + N^n_t  (equation (46))
  - P = Π_K_t + Π_R_t + Π_D_t + Π_L_t  (equation (47))
  - GDP_t = Y^H_t + P^o_t Y^o_t
- Interpretation: total output plus return on foreign investments equals consumption, capital investments, government spending and net deposits in the national development fund.

### Key policy-design elements embedded in the government and central bank framework
- Government fiscal policy channels:
  - Direct use of oil revenue (ν Θ_t) and national development fund access (ρ_g F_t).
  - Transfers scaled by ρ_Γ affecting household consumption and labor supply.
  - Public investment G^p_t builds public capital and affects non-oil output.
- Central bank role:
  - Taylor-rule-based policy response to inflation and output gaps.
  - Use of national development fund resources to intervene in financial markets and to lend via central bank operations.

---

### 3 Results — model calibration, shocks, and propagation mechanisms

### Calibration and general setup
- Model calibrated to quarterly data for Iran’s economy from 1985-2015.
- Model is general, not specific to any single oil-exporting country; abstracts from exchange rate and external sector.
- Shocks specification:
  - Oil price and technology shocks assumed stationary and follow AR(1):
    - P^o_t = (1−ρ_o) P^o + ρ_o P^o_{t−1} + ε^o_t
    - log(A_t) = ρ_i log(A_{t−1}) + ε^a_t
    - ε^i ~ N(0, σ^2_i), i = P^o, A.

### Technology shocks (non-oil and oil-sector TFP)
- One-standard-deviation positive TFP shock in non-oil sector:
  - Increases non-oil output, wages, and labor employed.
  - Reduces oil production and revenues via labor reallocation when oil price unchanged.
  - Transfers diminish for a few periods as government oil revenues fall and households get wealthier.
  - Marginal cost falls on impact → inflation declines → central bank cuts policy rate → market rates fall.
  - Decline in rates reduces banking system net worth, deposit and government bond supply.
  - Return on capital follows productivity shock per equation (12); loan demand falls as firms decrease capital accumulation.
- Comparison scenarios and parameter cases:
  - No price stickiness: α_p = 0.
  - Higher oil-sector capital replacement cost: α_o = 0.1.
  - No Rotemberg adjustment cost in deposit bank: κ_D = 0.
  - No market power for deposit banks: ε_D = ∞.
  - Near perfect pass-through of rates through lending banks: η_D, η_B, η_L ≃ 0.
- Findings on scenario comparisons:
  - Higher α_o slightly dampens technology shock impact.
  - Absence of price stickiness materially alters monetary policy behavior.
  - Removing sticky rates and imperfect competition marginally changes results.
  - Quasi-perfect pass-through amplifies expansion following technology shock; deposit and interbank rates remain determined by deposit banks with monopolistic power.

- Oil-sector TFP shock of exactly "1 percent":
  - Generally same directional effects but more pronounced.
  - Increases oil revenues and transfers, prompting higher public investment and public capital accumulation.
  - On impact marginally reduces marginal cost and inflation → monetary policy reduces policy rate.

### Oil price shocks
- One-standard-deviation positive oil price shock:
  - Boosts oil revenue → increases oil-sector investment and capital stock → amplifies oil production and total output.
  - Induces an increase in labor demand in oil sector interpreted as a labor supply shock for non-oil sector → pushes up wages and non-oil prices.
  - Monetary policy initially raises policy rate in response to positive output and price gaps.
  - Over short to medium term, non-oil sector contraction pushes total labor and wages below steady state, reversing initial wage/price increases.
  - Rising oil revenues reduce government bond issuance and tax dependence; transfers increase leading households to work less and raise consumption.
  - Lower market rates (after central bank cuts) lead to non-oil firms substituting labor with capital → capital stock rises.
  - Oil fund initially overshoots due to revenues but subsequently injects resources into the banking system as deposits fall and loan demand rises; central bank lending complements injections until steady state resumes.
  - Interbank rate adjustment rigidity leads to an interbank rate increase smaller than central bank rate increase; lending banks prefer interbank borrowing.

- Scenario comparisons for oil shock:
  - No Calvo pricing (α_p = 0):
    - Retailers adjust prices instantly → dampens shock impact on variables.
    - Non-oil sector cannot raise prices → output falls and capital accumulation increases.
    - Government initially issues higher bonds to support transfers and public investment.
  - Higher oil re-investment:
    - GDP and consumption expand more; convergence to steady state slower.
    - Oil sector greedier for labor → non-oil output declines faster and more protractedly.
    - Monetary reaction remains protracted and rates stay low longer.

### Role of banking sector and financial frictions (application)
- Model purpose:
  - Introduce national development fund and link to banking sector and government.
  - Analyze interbank market effects and differentiated market rates.
- Findings on financial frictions:
  - Deposit bank monopolization or deposit rate adjustment cost has mild impact.
  - Lending bank adjustment costs are critical: removing them (instantaneous rate changes) has significant effects.
    - Case with κ_D = 0 and ε_D = inf examined; also η_B,D,L = 0 examined.
    - With instantaneous lending rate adjustments, non-oil firms substitute labor with capital earlier → initial labor demand falls and investment soars.
    - Price index falls → central bank cuts policy rate → investment further boosts; after two quarters non-oil output rises and labor overshoots.
    - Consumption declines initially but rises as transfers and labor rebound; cumulative GDP impact higher than benchmark in this scenario.
  - Sensitivity: results are very sensitive to parameter calibration (household labor utility, Taylor rule).

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### 4 Concluding remarks — policy implications and limitations
- Main qualitative results:
  - Labor market complementarities across oil and non-oil sectors make labor allocation a key channel for shock spillovers (oil-sector technology and oil price shocks).
  - Wage and price stabilization policies help prevent large swings of production factors between sectors and stabilize monetary policy behavior.
  - Government plays an essential role in propagating shocks: higher oil revenues lead to magnified transfers and public capital expenditure, increasing consumption but affecting labor supply and enhancing fiscal multipliers through public capital used in non-oil output.
  - Banks amplify but do not fundamentally drive oil shock propagation in this model; lending-bank frictions (adjustment costs) matter more than deposit-bank market power.
- Policy-relevant takeaways:
  - Stabilizing wages and prices can act as automatic stabilizers across sectors.
  - Managing government use of oil revenues (transfers versus public investment) critically affects non-oil sector outcomes and fiscal multipliers.
  - Financial-sector design that reduces lending-rate rigidities can materially change transmission from oil shocks to the real economy.
- Model limitations and possible extensions:
  - Sensitivity to labor market specification; real-world oil sector is capital intensive with specialized labor and low substitutability.
  - Absence of exchange rate and trade; modeling a small open economy with a real exchange rate could exacerbate negative spillovers from oil to non-oil sector (Dutch disease effects).
  - Introducing credit-constrained firms, collaterals, and default would embed a financial accelerator and make banking central to shock propagation.
  - Incorporating an exchange-rate stabilization objective and an intervention rule for the central bank could improve dynamics for many oil-exporting countries.

*Source: wp18226 - 2.7 Government (PDF chapter/section).*

### References

### References

### Bibliographic citations (selected)
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- Berg, A., Portillo, R., Yang, S.-C. S., and Zanna, L.-F. (2013). Public investment in resource-abundant developing countries. IMF Economic Review, 61(1):92–129.
- Bhattacharjee, A., Thoenissen, C., et al. (2007). Money and monetary policy in dsge models. In Money Macro and Finance (MMF) Research Group Conference 2006, number 78. Citeseer.
- Chemingui, M. A. and Roe, T. (2008). Petroleum revenues in Gulf Cooperation Council, countries and their labor market paradox. Journal of Policy Modeling, 30(3):491–503.
- Choudhary, M. A. and Limodio, N. (2017). Deposit Volatility, Liquidity and Long-Term Investment: Evidence from a Natural Experiment in Pakistan. Technical report.
- Christiano, L., Rostagno, M., and Motto, R. (2010). Financial factors in economic fluctuations. Working Paper Series 1192, European Central Bank.
- Christiano, L. J., Eichenbaum, M., and Evans, C. L. (2005). Nominal rigidities and the dynamic effects of a shock to monetary policy. Journal of political Economy, 113(1):1–45.
- Daliri, H. and Mehrgan, N. (2015). The anatomy of dsge models with banking industry for iran’s economy. Iranian Journal of Economic Studies, 4(2):17–49.
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### Appendix — calibrated parameters (quarterly)
- Discount factors: β 0.9595, R_D = 0.18(annually)
- Consumption elasticity σ 1.5 (Bhattacharjee et al.(2007))
- Relative utility weight of labor χ_N 0.52, N = 1
- Inverse Frisch elasticity of labor supply φ 2.17 (Motevaseli et al.(2011))
- Elasticity of private capital γ_n 0.30, K/GDP = 2
- Elasticity of public capital γ_G 0.1 (Berg et al.(2013))
- Elasticity of private capital in oil γ_o 0.80, K_o/GDP = 0.30
- Coef. of intermediate producer θ, χ, α_p 9, 0.241, 0.503; 0% Mark up (Daliri and Mehrgan(2015))
- Depreciation rates δ_k, δ_o, δ_g 0.05, 0.007, 0.1 (Motevaseli et al.(2011))
- Capital Pro. adj. cost ξ 2 (Daliri and Mehrgan(2015))
- Coef. of deposit bank ε, κ_D 237, 1.5, R_IB = 0.20(annually)
- Taxes τ_c, τ_d, τ_w, τ_k 0.09, 0, 0.04, 0.15 (Average tax rates)
- Central bank ρ_cb, ρ_π, ρ_y 0.10, 1.5, 0.125 (Gertler and Karadi(2011))
- Oil AR processes ρ_o 0.80 (Guerra-Salas(2014))
- Other AR processes ρ_A, ρ_Ao, ρ_ξ 0.80, 0.90, 0.90
- Gov. share of oil revenue ν 0.70
- Gov usage of oil fund ρ_g 0.05
- Share of Transfer in Oil Rev. ρ_Γ 0.33
- Share of investment in oil revenue α_o 0.01
- Adj. costs of lending bank η_D, η_B, η_L 2, 0.2, 2

### Appendix — steady state of the benchmark model (quarter)
- Consumption C 0.64 (Steady State/GDP)
- Transfer Γ 0.05
- Private capital K 2
- Oil capital K_o 0.36
- Public capital K_G 0.48
- Non-oil output P_H Y_H 0.75
- Oil revenue P_o Y_o 0.25
- Gov. expenditure G_c, G_p, G 0.25, 0.046, 0.30
- Investment X 0.10
- Gov. loans B 0.40
- Tax T 0.09
- Total government’s budget 0.78
- Current expenditure/investment G_c/G_p 5.5

### Figures and captions (selected)
- Figure 1: Oil Revenue to export — country bars including United Arab Emirates, Bahrain, Iran, Qatar, Oman, Saudi Arabia, Kuwait, Iraq.
- Figure 2: Oil Revenue to GDP — country bars including Iran, United Arab Emirates, Bahrain, Qatar, Saudi Arabia, Oman, Iraq, Kuwait.
- Figure 3: IMF fiscal breakeven price.
- Figure 4: Market Capitalization/GDP - 2017 — country bars including Kazakhstan, Oman, Bahrain, Saudi Arabia, United Arab Emirates, Kuwait, Qatar.
- Figure 5: Public Investment/GDP - 2017.
- Figure 6: Private Investment/GDP - 2017.
- Figures 7–11: Impulse-response plots — percentage change from the steady state for key variables across 0–20 Quarters under various 1% standard deviation positive shocks:
  - Figure 7: Technology shock to non-oil firms. Benchmark model compared to no price stickiness (α_p = 0) and higher cost of capital replacement in the oil sector (α_o = 0.1).
  - Figure 8: Technology shock to non-oil firms. Benchmark model compared with models without Rotemberg adjustment cost in the deposit bank (κ_D = 0), no market power for deposit banks (ε_D = ∞), and near perfect pass-through of rates through lending banks (η_D, η_B, η_L ≃ 0).
  - Figure 9: Technology shock to the oil sector. Benchmark model compared to no price stickiness (α_p = 0) and higher cost of capital replacement in the oil sector (α_o = 0.1).
  - Figure 10: Technology shock to the oil sector. Benchmark model compared to no price stickiness (α_p = 0) and higher cost of capital replacement in the oil sector (α_o = 0.1).
  - Figure 11: Positive shock to the oil price. Benchmark model compared with κ_D = 0, ε_D = ∞, and η_D, η_B, η_L ≃ 0 scenarios.

*Source: wp18226 - References (PDF).*

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_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp18226.pdf_