## _wp0645

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---

### Model framework and key mechanisms
- Two-region NOEM model with overlapping generations (finite planning horizons) and non-Ricardian features:
  - Ricardian equivalence violated for three reasons: (i) overlapping-generations structure with newly born agents arriving without assets; (ii) distortionary labor and corporate income taxes (labor effort and capital formation respond to tax wedges); (iii) a share of wage income accrues to rule-of-thumb consumers who consume one-for-one with after-tax labor income.
- Asset and market features:
  - Asset markets incomplete; only nominal non-contingent bonds traded internationally and denominated in the home currency.
  - Complete home bias in equity and government debt holdings.
  - Law of one price for intermediate traded inputs; PPP can be violated due to nontraded goods and home bias.
- Household preferences and decisions:
  - Lifetime expected utility: U_{a,t} = E_t Σ_{s=t}^∞ (qβ)^{s−t} [ (C_{a,s}^η (1−L_{a,s})^{1−η})^{1−ρ}/(1−ρ) + χ/(1−ρ) (M_{a,s}/P_s)^{1−ρ} ].
  - Planning horizon: 1/(1−q) with q the survival probability.
  - Rule-of-thumb consumption: P_t C_{rot,t} = Ψ(W_t L_t (1−τ_{L,t}) + Φ_t).
- Firms and production:
  - Intermediate firms produce differentiated traded or nontraded goods under monopolistic competition.
  - Final goods: private consumption C_t (CES of tradables and nontradables), public consumption G_t (nontraded), and investment good (includes adjustment costs CAC).
  - Production technology: CES between capital and labor with elasticity parameter ξ; capital accumulation K_{i,t+1} = (1−δ)K_{i,t} + I_{i,t}; quadratic adjustment costs CAC_{i,t} = ψ/2 (I_{i,t})^2 / K_{i,t}.
  - Profit maximization yields pricing P_{i,t} = θ/(θ−1) MC_{i,t}.
- Government and fiscal rule:
  - Government budget constraint (nominal): P_{G,t} G_t + (1+i_t) B_t = T_t + (M_t − M_{t−1}) + B_{t+1}.
  - Tax adjustment rule with debt gap: τ_t = κ_{1,t} (τ_t + DEBTGAPS) + (1−κ_{1,t}) τ̄_t, where DEBTGAPS = [B_t/GDP_t − v_1 b^*_t − (1−v_1) B_{t−1}/GDP_{t−1}] + v_2 [ΔB_t/GDP_t − Δb^*_t].
  - Recommended calibration for experiments uses (v_1, v_2) = (0.1, 1.0) to avoid excessive tax-rate cycling.

### Calibration, experiments, and key parameter values
- Two country sizes in experiments:
  - Small home economy: 1percent of world GDP.
  - Large home economy: 60percent of world GDP (approximate OECD share in the 1980s).
- Baseline structural parameters (examples cited in text):
  - Effective planning horizon baseline: 10 years ⇒ q = 0.90.
  - Alternative planning horizon: 20 years ⇒ q = 0.95.
  - Intertemporal elasticity of substitution: 1/ρ = 0.20 ⇒ ρ = 5 (alternative considered: 1/3 ⇒ ρ = 3).
  - Elasticity of labor supply parameter: η = 0.96.
  - Share of rule-of-thumb (liquidity-constrained) consumers: Ψ = 25percent.
  - Elasticity of substitution between home and foreign goods: 1/ω with ω = 2.5 (1/ω ≈ 0.40).
  - Elasticity of substitution between capital and labor χ = 0.8 (Cobb-Douglas case considered: χ = 1).
- Baseline steady state:
  - Steady-state real interest rate targeted at 3 percent.
  - Initial government debt assumed to be zero in baseline steady state.
- Fiscal shock experiment:
  - Debt-financed cut in labor income taxes that increases the primary deficit by 1 percent of GDP for 10 years (κ_{1,t} = 0 for t = 1,...,10); from year 11 tax rule reactivated to stabilize debt-to-GDP at new steady state.

### Main quantitative findings — small open economy (home = 1percent)
- Fiscal outcomes and external position:
  - Government debt-to-GDP ratio rises to about 12 percentage points higher than baseline after 10 years following the 1 percent of GDP primary deficit shock for 10 years.
  - Net foreign assets (NFA-to-GDP ratio) declines by a similar magnitude and converges slower to the new steady state.
  - Over the first 10 years, the current account balance declines by around half the amount of the fiscal balance.
- Real economy responses:
  - Short run (first 10 years): real GDP, consumption, and labor effort rise; investment is crowded out by higher real interest rates.
  - Rule-of-thumb consumers: consumption rises by almost 3 percent as they respond one-for-one to after-tax labor income.
  - Optimizing agents: consumption response muted because they partially anticipate future tax burdens.
  - Long run: higher taxes, lower profits, and real exchange rate depreciation reduce real wealth; real GDP, capital stock, and consumption decline permanently; labor effort falls only modestly due to low labor supply elasticity.
- Corporate income tax cut (analogous experiment):
  - Qualitatively similar to labor tax cut; differences:
    - Short-run consumption and GDP increase slightly less (rule-of-thumb consumers do not benefit directly).
    - Short-run investment boom is larger but short-lived because of rising real interest rates.
    - Long-run GDP decline larger than with labor tax cut because future higher corporate taxes are more distortionary for capital formation.

### Main quantitative findings — large open economy (home = 60percent)
- World interest rate and crowding out:
  - Large accumulation of government debt has significant permanent effects on the world real interest rate.
  - Empirical mapping: each 12.5 percentage point increase in the government debt ratio raises the real interest rate by about 100 basis points.
  - Therefore, a 20 percentage point increase in government debt (example from OECD during the 1980s) would account for about a 160 basis point increase in real interest rates.
- Real economy and spillovers:
  - Rising world real interest rate causes substantial declines in investment and larger long-run crowding-out of GDP in both home and foreign economies compared to the small-economy case.
  - Short-run output multiplier smaller than in the small-economy case due to immediate higher interest rates.
  - Corporate tax cuts in a large economy produce slightly larger world real interest rate increases and correspondingly larger spillovers.

### Sensitivity analysis — parameters with largest quantitative influence
- Most influential parameter: effective planning horizon (q)
  - Longer planning horizons (higher q, e.g., q = 0.95 ⇒ 20 years) make optimizing agents more Ricardian, reducing the short-run increase in consumption and output and moderating the increase in current account deficits and real interest rates.
- Other important parameters (especially for large open economy):
  - Elasticity of labor supply (η): making labor supply more inelastic reduces labor effort responses but increases long-run crowding-out via required interest rate adjustments.
  - Intertemporal elasticity of substitution (1/ρ): higher values reduce sensitivity of interest rates to deficits and therefore reduce crowding out.
  - Share of rule-of-thumb consumers (Ψ): eliminating rule-of-thumb consumers makes the model more Ricardian and lowers long-run interest rate effects and spillovers.
  - Elasticity of substitution between capital and labor (χ): higher substitutability (closer to Cobb-Douglas, χ = 1) reduces long-run output declines following deficit-financed corporate tax cuts by allowing factor substitution.
- Robustness checks (selected numeric highlights from sensitivity tables):
  - Small-open, cut in labor taxes (selected rows):
    - Government debt to GDP Impact: 1.11 (Baseline) with 11th Year: 12.29 and Long run: 12.00.
    - Net foreign assets to GDP Impact: -0.72 (Baseline) with 11th Year: -7.35 and Long run: -11.88.
    - Real interest rate Impact: 0.18 (Impact) and First 10 years (average): 0.09; Long run: 0.01.
    - Real GDP Impact: 0.37 (Impact).
    - Consumption Impact: 1.68 (Impact).
    - Investment Impact: -1.12 (Impact).
  - Small-open, cut in corporate taxes (selected rows):
    - Government debt to GDP Impact: 1.08 (Baseline) with 11th Year: 11.93 and Long run: 12.00.
    - Net foreign assets to GDP Impact: -0.48 (Baseline) with 11th Year: -4.08 and Long run: -13.22.
    - Real interest rate Impact: -0.01 (Impact) and Long run: 0.02.
    - Investment Impact: 1.79 (Impact).
  - Large-open, cut in labor taxes (selected rows):
    - Government debt to GDP Impact: 1.05 (Baseline) with 11th Year: 12.12 and Long run: 12.00.
    - Net foreign assets to GDP Impact: -0.28 (Baseline) with 11th Year: -2.90 and Long run: -4.83.
    - Real interest rate Impact: 0.23 (Impact); First 10 years (average): 0.33; Long run: 0.90.
    - Investment Impact: -3.32 (Impact).
    - Foreign economy Real GDP Long run: -3.14; Investment Long run: -8.35.
  - Large-open, cut in corporate taxes (selected rows):
    - Government debt to GDP Impact: 1.03 (Baseline) with 11th Year: 11.91 and Long run: 12.00.
    - Net foreign assets to GDP Impact: -0.18 (Baseline) with 11th Year: -1.60 and Long run: -5.20.
    - Real interest rate Impact: -0.04 (Impact); First 10 years (average): 0.12; Long run: 0.97.
    - Investment Impact: 0.68 (Impact) in home economy; Foreign economy Investment Long run: -8.97.

### Policy-relevant conclusions and implications
- Non-Ricardian mechanisms matter: overlapping generations, distortionary taxation, and rule-of-thumb consumers generate persistent effects of government debt on savings, net foreign assets, and world real interest rates.
- Size of economy matters:
  - Small open economies: debt accumulation shows up mainly as higher net foreign liabilities with limited spillovers.
  - Large economies or groups of economies: debt accumulation raises the world real interest rate and produces substantial global spillovers and crowding out.
- Tax instrument choice:
  - Corporate income taxes can be more distortionary than labor income taxes in this model (though corporate taxation here is less distortionary than in perfect competition models because some tax falls on monopolistic rents).
- Key policy design insight:
  - The effective planning horizon of agents is the key determinant of the real effects of government debt—more so than the mere presence of liquidity-constrained consumers or distortionary taxes.
- Suggested model extensions for policy analysis:
  - Multi-region extension, nominal and real rigidities for short-run analysis, additional tax bases (e.g., VAT and personal income taxes), and financial accelerator mechanisms for emerging market applications.

*Source: _wp0645 (PDF), https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp0645.pdf*

### References..........................................  23

### _wp0645 - References..........................................  23

### Model framework and key mechanisms
- Two-region NOEM model with overlapping generations (finite planning horizons) and non-Ricardian features:
  - Ricardian equivalence violated for three reasons: (i) overlapping-generations structure with newly born agents arriving without assets; (ii) distortionary labor and corporate income taxes (labor effort and capital formation respond to tax wedges); (iii) a share of wage income accrues to rule-of-thumb consumers who consume one-for-one with after-tax labor income.
- Asset and market features:
  - Asset markets incomplete; only nominal non-contingent bonds traded internationally and denominated in the home currency.
  - Complete home bias in equity and government debt holdings.
  - Law of one price for intermediate traded inputs; PPP can be violated due to nontraded goods and home bias.
- Household preferences and decisions:
  - Lifetime expected utility: U_{a,t} = E_t Σ_{s=t}^∞ (qβ)^{s−t} [ (C_{a,s}^η (1−L_{a,s})^{1−η})^{1−ρ}/(1−ρ) + χ/(1−ρ) (M_{a,s}/P_s)^{1−ρ} ].
  - Planning horizon: 1/(1−q) with q the survival probability.
  - Consumption of optimizing agents decomposed into human wealth and financial holdings; rule-of-thumb consumption: P_t C_{rot,t} = Ψ(W_t L_t (1−τ_{L,t}) + Φ_t).
- Firms and production:
  - Intermediate firms produce differentiated traded or nontraded goods under monopolistic competition.
  - Final goods: private consumption C_t (CES of tradables and nontradables), public consumption G_t (nontraded), and investment good (includes adjustment costs CAC).
  - Production technology: CES between capital and labor with elasticity parameter ξ; capital accumulation K_{i,t+1} = (1−δ)K_{i,t} + I_{i,t}; quadratic adjustment costs CAC_{i,t} = ψ/2 (I_{i,t})^2 / K_{i,t}.
  - Profit maximization yields pricing P_{i,t} = θ/(θ−1) MC_{i,t}.
- Government and fiscal rule:
  - Government budget constraint (nominal): P_{G,t} G_t + (1+i_t) B_t = T_t + (M_t − M_{t−1}) + B_{t+1}.
  - Tax adjustment rule with debt gap: τ_t = κ_{1,t} (τ_t + DEBTGAPS) + (1−κ_{1,t}) τ̄_t, where DEBTGAPS = [B_t/GDP_t − v_1 b^*_t − (1−v_1) B_{t−1}/GDP_{t−1}] + v_2 [ΔB_t/GDP_t − Δb^*_t].
  - Recommended calibration for experiments uses (v_1, v_2) = (0.1, 1.0) to avoid excessive tax-rate cycling.

### Calibration, experiments, and key parameter values
- Two country sizes in experiments:
  - Small home economy: 1percent of world GDP.
  - Large home economy: 60percent of world GDP (approximate OECD share in the 1980s).
- Baseline structural parameters (examples cited in text):
  - Effective planning horizon baseline: 10 years ⇒ q = 0.90.
  - Alternative planning horizon: 20 years ⇒ q = 0.95.
  - Intertemporal elasticity of substitution: 1/ρ = 0.20 ⇒ ρ = 5 (alternative considered: 1/3 ⇒ ρ = 3).
  - Elasticity of labor supply parameter: η = 0.96.
  - Share of rule-of-thumb (liquidity-constrained) consumers: Ψ = 25percent.
  - Elasticity of substitution between home and foreign goods: 1/ω with ω = 2.5 (1/ω ≈ 0.40).
  - Elasticity of substitution between capital and labor χ = 0.8 (Cobb-Douglas case considered: χ = 1).
- Baseline steady state:
  - Steady-state real interest rate targeted at 3 percent.
  - Initial government debt assumed to be zero in baseline steady state.
- Fiscal shock experiment:
  - Debt-financed cut in labor income taxes that increases the primary deficit by 1 percent of GDP for 10 years (κ_{1,t} = 0 for t = 1,...,10); from year 11 tax rule reactivated to stabilize debt-to-GDP at new steady state.

### Main quantitative findings — small open economy (home = 1percent)
- Fiscal outcomes and external position:
  - Government debt-to-GDP ratio rises to about 12 percentage points higher than baseline after 10 years following the 1 percent of GDP primary deficit shock for 10 years.
  - Net foreign assets (NFA-to-GDP ratio) declines by a similar magnitude and converges slower to the new steady state.
  - Over the first 10 years, the current account balance declines by around half the amount of the fiscal balance.
- Real economy responses:
  - Short run (first 10 years): real GDP, consumption, and labor effort rise; investment is crowded out by higher real interest rates.
  - Rule-of-thumb consumers: consumption rises by almost 3 percent as they respond one-for-one to after-tax labor income.
  - Optimizing agents: consumption response muted because they partially anticipate future tax burdens.
  - Long run: higher taxes, lower profits, and real exchange rate depreciation reduce real wealth; real GDP, capital stock, and consumption decline permanently; labor effort falls only modestly due to low labor supply elasticity.
- Corporate income tax cut (analogous experiment):
  - Qualitatively similar to labor tax cut; differences:
    - Short-run consumption and GDP increase slightly less (rule-of-thumb consumers do not benefit directly).
    - Short-run investment boom is larger but short-lived because of rising real interest rates.
    - Long-run GDP decline larger than with labor tax cut because future higher corporate taxes are more distortionary for capital formation.

### Main quantitative findings — large open economy (home = 60percent)
- World interest rate and crowding out:
  - Large accumulation of government debt has significant permanent effects on the world real interest rate.
  - Empirical mapping: each 12.5 percentage point increase in the government debt ratio raises the real interest rate by about 100 basis points.
  - Therefore, a 20 percentage point increase in government debt (example from OECD during the 1980s) would account for about a 160 basis point increase in real interest rates.
- Real economy and spillovers:
  - Rising world real interest rate causes substantial declines in investment and larger long-run crowding-out of GDP in both home and foreign economies compared to the small-economy case.
  - Short-run output multiplier smaller than in the small-economy case due to immediate higher interest rates.
  - Corporate tax cuts in a large economy produce slightly larger world real interest rate increases and correspondingly larger spillovers.

### Sensitivity analysis — parameters with largest quantitative influence
- Most influential parameter: effective planning horizon (q)
  - Longer planning horizons (higher q, e.g., q = 0.95 ⇒ 20 years) make optimizing agents more Ricardian, reducing the short-run increase in consumption and output and moderating the increase in current account deficits and real interest rates.
- Other important parameters (especially for large open economy):
  - Elasticity of labor supply (η): making labor supply more inelastic reduces labor effort responses but increases long-run crowding-out via required interest rate adjustments.
  - Intertemporal elasticity of substitution (1/ρ): higher values reduce sensitivity of interest rates to deficits and therefore reduce crowding out.
  - Share of rule-of-thumb consumers (Ψ): eliminating rule-of-thumb consumers makes the model more Ricardian and lowers long-run interest rate effects and spillovers.
  - Elasticity of substitution between capital and labor (χ): higher substitutability (closer to Cobb-Douglas, χ = 1) reduces long-run output declines following deficit-financed corporate tax cuts by allowing factor substitution.
- Robustness checks:
  - Degree of home bias in government spending matters little for main qualitative results (complete home bias assumed in baseline).
  - Introducing home bias in private consumption reduces trade balance sensitivity to real exchange rate changes, requiring larger long-run real depreciations to generate needed trade surpluses.

### Policy-relevant conclusions and implications
- Non-Ricardian mechanisms matter: overlapping generations, distortionary taxation, and rule-of-thumb consumers generate persistent effects of government debt on savings, net foreign assets, and world real interest rates.
- Size of economy matters:
  - Small open economies: debt accumulation shows up mainly as higher net foreign liabilities with limited spillovers.
  - Large economies or groups of economies: debt accumulation raises the world real interest rate and produces substantial global spillovers and crowding out.
- Tax instrument choice:
  - Corporate income taxes can be more distortionary than labor income taxes in this model (though corporate taxation here is less distortionary than in perfect competition models because some tax falls on monopolistic rents).
- Key policy design insight:
  - The effective planning horizon of agents is the key determinant of the real effects of government debt—more so than the mere presence of liquidity-constrained consumers or distortionary taxes.
- Suggested model extensions for policy analysis:
  - Multi-region extension, nominal and real rigidities for short-run analysis, additional tax bases (e.g., VAT and personal income taxes), and financial accelerator mechanisms for emerging market applications.

*Source: _wp0645 - References (PDF), https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp0645.pdf*

### References

### _wp0645 - References

### Methods and Simulation
- Armstrong,J.,D.Black,D.Laxton,andD.Rose,1998, "A Robust Method for Simulating Forward-Looking Models,"Journal of Economic Dynamics and Control, Vol. 22, pp. 489—501.
- Black, R., D. Laxton, R. David, and R. Tetlow,1994, "The Steady-State Model: SSQPM - The Bank of Canada’s New Quarterly Projection Model, Part 1," Bank of Canada Technical Report No. 72, Ottawa.
- Black,R.,V.Cassino,A.Drew,E.Hansen,B.Hunt,D.Rose,andA.Scott,1997,"The Forecasting and Policy System: The Core Model," Reserve Bank of New Zealand Research Paper No. 43, Wellington.

### Consumption, Interest Rates, and Aggregation
- Attanasio, O.P., and Weber, G.,1993, "Consumption Growth, the Interest Rate and Aggregation ,"Review of Economic Studies, Vol. 60, pp. 631—99.

### Fiscal Policy, Tax Reform, and Social Security
- Bayoumi, T., D. Botman, and M. Kumar,2005,"Effects of Social Security and Tax Reform in the United States," United States–Selected Issues, IMF Country Report No. 05/258 (Washington, D.C.: International Monetary Fund).
- Bayoumi, T., D. Botman, D. Laxton, and D. Muir,2005,"Jam TodayorMore Jam Tomorrow? On Cutting Taxes Now versus Later," Canada–Selected Issues, IMF Country Report No. 05/116 (Washington, D.C.: International Monetary Fund).
- Botman, D., and D. Laxton,2004,"TheEffects of Tax Cuts in a Global Fiscal Model,"

### Exchange Rates, Open Economy Macroeconomics, and International Linkages
- Bayoumi, T., M. Kumhof, D. Laxton, and K. Naknoi,2004, "Exchange Rate Regimes, International Linkages, and the Macroeconomic Performance of the New Member States" paper prepared for the Fifth IMF Jacques Polak Annual Research Conference: Policies, Institutions, and Instability, Washington, DC, November 4—5, 2004. Conference version available via the Internet: http://www.imf.org/external/pubs/ft/staffp/2004/00-00/arc.htm.
- Bayoumi,T.,D.Laxton,andP.Pesenti2004,"Benefits and Spillovers of Greater Competition in Europe: A Macroeconomic Assessment," NBER Working Paper 10416(Cambridge, Massachusetts: National Bureau of Economic Research).
- Bergin, P. R.,2004, "How Well Can the New Open Economy Macroeconomics Explain the Exchange Rate and Current Account?" NBER Working Paper10356(Cambridge, Massachusetts: National Bureau of Economic Research).
- Betts, C., and M. Devereux,2001, "The International Monetary Transmission of Monetary and Fiscal Policies in a Two-Country Model," inEssays in Honor of Robert A. Mundell, by M. Obstfeld, and G. Calvo (Cambridge Massachusetts: The MIT Press).

### Monetary Transmission and Financial Accelerator
- Bernanke, B., M. Gertler, and S. Gilchrist,1999, "The Financial Accelerator in a Quantitative Business Cycle Framework," inThe Handbook of Macroeconomics,byJ. Taylor and M. Woodford (Amsterdam: North Holland).

### Debt, Deficits, and Government Spending
- Blanchard, O.J.,1985,"Debt,Deficits, and Finite Horizons,"Journal of Political Economy, Vol. 93, pp. 223-47.
- Blanchard, O.J., and R. Perotti,2002, "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output,"Quarterly Journal of Economics, Vol. 117 (4), pp. 1329-68.

*Source: _wp0645 - References*

### Box 2.2 inWorld Economic Outlook, April (Washington, D.C.: International

### Box 2.2 (World Economic Outlook, April — Internal Box content)

### Key references cited
- Buiter, W.H., 1981, "Time Preference and International Lending and Borrowing in an Overlapping-Generations Model," Journal of Political Economy, Vol. 89, pp. 769-97.
- Caselli, P., 2001, "Fiscal Consolidation Under Fixed Exchange Rates," European Economic Review, Vol. 45 (3), pp. 425-50.
- Chari, V.V., P. Kehoe, and E. McGrattan, 2000, "Stick Price Models of the Business Cycle: Can the Contract Multiplier Solve the Persistence Problem?," Econometrica, Vol. 68 (5), September, pp. 1151-79.
- Christiano, L.J., M. Eichenbaum, and C. Evans, 2001, "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," NBER Working Paper 8403.
- Corsetti, G., and P. Pesenti, 2001, "Welfare and Macroeconomic Interdependence," Quarterly Journal of Economics, Vol. 116, pp. 421-45.
- Erceg, C.J., L. Guerrieri, and C. Gust, 2005, "Expansionary fiscal shocks and the trade deficit," International Finance Discussion Paper, 825.
- Faruqee, H., and D. Laxton, 2000, "Life-Cycles, Dynasties, Saving: Implications for Closed and Small Open Economies," IMF Working Paper 00/126.
- Faruqee, H., D. Laxton, and Steven Symansky, 1997, "Government Debt, Life-Cycle Income and Liquidity Constraints: Beyond Approximate Ricardian Equivalence," IMF Staff Papers, Vol. 44 (September), pp. 374-82.
- Fatas, A., and I. Mihov, 2001, "The Effects of Fiscal Policy on Consumption and Employment: Theory and Evidence," Mimeo, INSEAD.
- Ford, R., and D. Laxton, 1999, "World Public Debt and Real Interest Rates," Oxford Review of Economic Policy, Vol. 15 (2), pp. 77-94.
- Frenkel, J.A., and A. Razin, 1992, Fiscal Policies and the World Economy, Second Edition.
- Gali, J., J. David López-Salido, and J. Vallés, 2003, "Understanding the Effects of Government Spending on Consumption," Mimeo, CREI.
- Ganelli, G., 2003a, "Useful Government Spending, Direct Crowding-Out, and Fiscal Policy Interdependence," Journal of International Money and Finance, Vol. 22 (1), pp. 87-103.
- Ganelli, G., 2003b, "The New Open Economy Macroeconomics of Government Debt," Journal of International Economics, Vol. 65 (1), pp. 167-84.
- Ganelli, G., and P.R. Lane, 2002, "Dynamic General Equilibrium Analysis: the Open Economy Dimension," in Dynamic Macroeconomic Analysis.
- Ghironi, F., T.B. Iscan, and A. Rebucci, 2005, "Net Foreign Asset Positions and Consumption Dynamics in the International Economy," IMF Working Paper 05/82.
- Julliard, M., and D. Laxton, 1996, "A Robust and Efficient Method for Solving Nonlinear Rational Expectations Models," IMF Working Paper 96/111.
- Juilliard, M., D. Laxton, H. Pioro, and P. McAdam, 1998, "An Algorithm Competition: First Order Iterations Versus Newton-Based Techniques," Journal of Economic Dynamics and Control, Vol. 22, pp. 1291-1318.
- Kumhof, M., D. Laxton, and D. Muir, 2005, "Consequences of Fiscal Consolidation for the U.S. Current Account," United States–Selected Issues, IMF Country Report No. 05/258.
- Lane, P.R., and G.M. Milesi-Ferretti, 2002, "Long-Term Capital Movements," in NBER Macroeconomics Annual 2001.
- Laxton, D., P. Isard, H. Faruqee, E. Prasad, and B. Turtleboom, 1998, MULTIMOD Mark III: The Core Dynamic and Steady-State Models, IMF Occasional Paper 164.
- Laxton, D., and P. Pesenti, 2003, "Monetary Rules for Small, Open, Emerging Economies," Journal of Monetary Economics, Vol. 50 (5), pp. 1109-52.
- McKibbin, W.J., and J.D. Sachs, 1991, Global Linkages: Macroeconomic Interdependence and Cooperation in the World Economy.
- Obstfeld, M., and K. Rogoff, 1995, "Exchange Rate Dynamics Redux," Journal of Political Economy, Vol. 103, pp. 624-60.
- Obstfeld, M., and K. Rogoff, 1996, Foundations of International Macroeconomics.
- Obstfeld, M., and K. Rogoff, 2000, "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?"
- Patterson, K., and B. Pesaran, 1992, "Intertemporal Elasticity of Substitution in Consumption in the United States and the United Kingdom," Review of Economics and Statistics, Vol. 74, pp. 573-84.
- Weil, P., 1989, "Overlapping Families of Infinitely-Lives Agents," Journal of Public Economics, Vol. 38, pp. 183-98.

### Baseline parameters (Table 1)
- Discount Rate β: 0.99
- Depreciation Rate on Capital δ: 0.10
- Capital Adjustment Cost Parameter ψ: 2.00
- Elasticity of Substitution between Varieties θ:
  - Tradables sector: 6.00
  - Price Markup θ/(θ-1): 1.20
  - Nontradables sector: 3.50
  - Price Markup θ/(θ-1): 1.40
- Capital Share in Production:
  - Tradables Sector μ_T: 0.50
  - Nontradables Sector μ_N: 0.50
- Utility from Real Money Balances χ: 0.02
- Price Stickiness Parameter φ: 0.00
- Home Bias in Government Consumption: yes
- Home Bias in Consumption:
  - Home Economy ¡α_H = n¢: no
  - Foreign Economy ¡α_F = n¢: no
- Elast. of Subst. between Traded and Nontraded goods 1/(≈1.33): 0.75
- Home Bias towards Traded Goods γ: 0.40
- Steady-state inflation (the inflation target): 0.02

### Baseline parameters varied for sensitivity analysis (Table 2)
- Size of the Home Economy n:
  - if home economy is small: 0.01
  - if home economy is large: 0.60
- Planning Horizon of Consumers (1/q): 10 Years
- Labor Disutility Parameter η: 0.96
- Share of Rule-of-thumb-consumers: 0.25
- Intertemporal Elasticity of Substitution 1/ρ (ρ=5.0): 0.20
- Elast. of Subst. between Home and Foreign Goods 1/ω (ω=2.5): 0.40
- Elasticity of Substitution between Capital and Labor χ: 0.80

### Initial steady-state ratios (Table 3)
- Sectoral Shares as a Ratio to Nominal GDP:
  - tradables sector: 0.31
  - nontradables sector: 0.69
- Labor Income Shares as a Ratio to Nominal GDP:
  - tradables sector: 0.62
  - nontradables sector: 0.62
- Consumption-to-Nominal GDP Ratios:
  - private consumption: 0.64
  - forward-looking: 0.55
  - rule-of-thumb: 0.09
- Government Consumption-to-Nominal-GDP Ratio: 0.20
- Investment-to-Nominal-GDP Ratios:
  - domestic: 0.10
  - imported: 0.06
- Exports-to-Nominal GDP Ratio: 0.31
- Imports-to-Nominal-GDP Ratio: 0.31
- NFA-to-Nominal-GDP Ratio: 0.00
- Real Interest Rate: 0.03
- Terms of Trade: 1.00
- Tax-Revenue-to-Nominal-GDP Ratio: 0.19
- Bilateral real exchange rate: 1.00

### Initial steady state of fiscal variables (Table 4)
- Government Debt to GDP S_Bt: 0.00
- Tax Rate on Total Income: 0.19
- Labor Income Tax Rate: 0.23
  - as a percent of total income: 0.11
- Corporate Income Tax Rate (on capital income): 0.15
  - as a percent of total income: 0.03
- Corporate Income Tax Rate (on dividend income): 0.15
  - as a percent of total income: 0.05

### Scenario experiments (figures overview)
- Figures 1–4 present dynamic deviations from control for policy experiments:
  - Ten-year 1.0 Percent of GDP Cut in Income Taxes (small-open and large-open cases).
  - Ten-year 1.0 Percent of GDP Cut in Corporate Taxes (small-open and large-open cases).
- Variables illustrated (deviation from control, in percentage points unless otherwise stated) include:
  - Revenue to GDP and labor vs. corporate tax rates (Rev., Labor, Corp.)
  - Government Debt and NFA to GDP (Debt, NFA)
  - Real GDP (GDP, percent)
  - Real Interest and Exchange Rate (Int., Exch., percent)
  - Consumption components (Total, ROT, Opt., percent)
  - Investment and Capital Stock (Inv., Cap., percent)
  - Labor Effort and Real Wage (Labor, Wage, percent)
  - Government Balance, Current Account, and Trade Balance to GDP (Gov., Cur., Trade)

### Sensitivity analysis — small-open economy, cut in labor taxes (Table 5 and Table 6)
- Variants considered:
  1. Longer planning horizon (q=0.95 → 1/η=1.0)
  2. Inelastic labor supply (ρ=3.0)
  3. Higher intertemporal elasticity of substitution (Ψ=0.0)
  4. Share of rule-of-thumb consumers (ξ=1.0)
  5. Higher elasticity of substitution between capital and labor
- Key numeric outcomes (selected):
  - Tax rate:
    - Impact: -1.00 across Baseline and variants
    - First 10 years (average): -1.00 across Baseline and variants
    - Long run: 0.35 across Baseline and variants
  - Government debt to GDP:
    - Impact: 1.11 (Baseline), 1.08, 1.11, 1.10, 1.09, 1.10
    - 11th Year: 12.29, 12.05, 12.29, 12.28, 12.13, 12.22
    - Long run: 12.00 across all
  - Net foreign assets to GDP:
    - Impact: -0.72, -0.54, -0.71, -0.65, -0.61, -0.74
    - 11th Year: -7.35, -5.30, -7.30, -7.16, -6.31, -7.35
    - Long run: -11.88, -12.02, -11.86, -11.88, -11.92, -11.87
  - Government balance to GDP:
    - Impact: -1.11, -1.08, -1.11, -1.10, -1.09, -1.10
    - First 10 years (average): -1.34, -1.31, -1.34, -1.33, -1.32, -1.33
    - Long run: -0.24 across all
  - Current Account balance to GDP and Trade Balance to GDP mirror NFA changes with:
    - Long run current account: -0.23 or -0.24 across variants
    - Trade Balance long run: 0.36 across variants
  - Real interest rate:
    - Impact: 0.18, 0.17, 0.18, 0.13, 0.15, 0.16
    - First 10 years (average): 0.09, 0.07, 0.09, 0.08, 0.06, 0.08
    - Long run: 0.01, 0.00, 0.02, 0.01, 0.01, 0.01
- Real exchange rate, Real GDP, Consumption, Investment, Labor effort, Real wage (Table 6):
  - Real exchange rate Impact: -0.92, -0.67, -0.92, -0.83, -0.77, -0.81
  - Real GDP Impact: 0.37, 0.30, 0.33, 0.34, 0.33, 0.38
  - Consumption Impact: 1.68, 1.30, 1.64, 1.47, 1.42, 1.64
  - Investment Impact: -1.12, -0.91, -1.22, -0.77, -0.89, -0.95
  - Labor effort Impact: 0.09, 0.11, 0.01, 0.10, 0.11, 0.08
  - Real wage Impact: 0.14, 0.08, 0.19, 0.12, 0.10, 0.17

### Sensitivity analysis — foreign economy effects, cut in labor taxes (Table 7)
- Foreign economy responses (small-open case):
  - Real GDP Impact: -0.00 across variants; First 10 years (average): -0.01 to -0.00; Long run: -0.05 to -0.02
  - Consumption Impact: Impact values reported as -0.00 or 0.00 across variants; Long run: -0.02 to -0.03
  - Investment Impact: Impact: -0.04 across most variants; First 10 years (average): -0.07 to -0.03; Long run: -0.14 to -0.05
  - Real interest rate long run: 0.01, 0.00, 0.02, 0.01, 0.01, 0.01
  - Labor effort and Real wage impacts show values near zero with Long run real wage: -0.07 to -0.02

### Sensitivity analysis — small-open economy, cut in corporate taxes (Tables 8–10)
- Tax rate:
  - Impact: -1.00 across Baseline and variants
  - Long run: 0.35 across Baseline and variants
- Government debt to GDP:
  - Impact: 1.08, 1.06, 1.08, 1.07, 1.08, 1.07
  - 11th Year: 11.93, 11.68, 11.90, 11.94, 11.91, 11.88
  - Long run: 12.00 across all
- Net foreign assets to GDP:
  - Impact: -0.48, -0.34, -0.48, -0.45, -0.46, -0.49
  - 11th Year: -4.08, -1.66, -4.02, -4.04, -4.01, -4.02
  - Long run: -13.22, -14.56, -13.23, -13.22, -13.17, -13.16
- Government balance to GDP:
  - Impact: -1.08 to -1.06; Long run: -0.24 across all
- Real interest rate Impact: -0.01, 0.02, 0.00, -0.03, -0.01, -0.03; Long run: 0.02, 0.01, 0.02, 0.01, 0.01, 0.02
- Real exchange rate, Real GDP, Consumption, Investment (Table 9):
  - Real exchange rate Impact: -0.65, -0.46, -0.65, -0.61, -0.62, -0.58
  - Real GDP Impact: 0.14, 0.10, 0.15, 0.13, 0.13, 0.15
  - Consumption Impact: 0.36, 0.17, 0.38, 0.25, 0.31, 0.35
  - Investment Impact: 1.79, 1.60, 1.77, 1.97, 1.83, 2.14
- Foreign economy responses (Table 10) show very small negative impacts on Real GDP, Consumption, Investment and small positive long-run real interest rate (0.02 or 0.01 across variants).

### Sensitivity analysis — large-open economy, cut in labor taxes (Tables 11–13)
- Tax rate Impact: -1.00; Long run tax rate: 0.48, 0.39, 0.50, 0.43, 0.45, 0.47 across variants
- Government debt to GDP:
  - Impact: 1.05, 1.04, 1.05, 1.05, 1.04, 1.04
  - 11th Year: 12.12, 11.87, 12.16, 12.10, 11.96, 12.09
  - Long run: 12.00 across all
- Net foreign assets to GDP:
  - Impact: -0.28, -0.21, -0.28, -0.25, -0.24, -0.29
  - 11th Year: -2.90, -2.11, -2.88, -2.83, -2.48, -2.91
  - Long run: -4.83 to -4.82 across variants
- Real interest rate:
  - Impact: 0.23, 0.41, 0.25, -0.03, 0.15, 0.24
  - First 10 years (average): 0.33, 0.20, 0.37, 0.21, 0.21, 0.33
  - Long run: 0.90, 0.29, 1.07, 0.48, 0.73, 0.86
- Real exchange rate, Real GDP, Consumption, Investment (Table 12):
  - Real exchange rate Impact: -0.88, -0.65, -0.88, -0.80, -0.74, -0.78
  - Real GDP Impact: 0.28, 0.25, 0.24, 0.22, 0.24, 0.28
  - Consumption Impact: 1.52, 1.35, 1.59, 0.90, 1.13, 1.48
  - Investment Impact: -3.32, -3.11, -3.82, -1.17, -2.15, -3.55
- Foreign economy responses (Table 13) show larger long-run negative effects in the large-open case:
  - Real GDP Long run: -3.14, -0.98, -3.59, -1.68, -2.55, -3.08
  - Investment Long run: -8.35, -2.79, -9.69, -4.62, -6.84, -9.15
  - Real interest rate Long run: 0.90, 0.29, 1.07, 0.48, 0.73, 0.86

### Sensitivity analysis — large-open economy, cut in corporate taxes (Tables 14–16)
- Tax rate Impact: -1.00; Long run tax rate: 0.49, 0.40, 0.51, 0.44, 0.46, 0.48 across variants
- Government debt to GDP:
  - Impact: 1.03, 1.02, 1.03, 1.03, 1.03, 1.03
  - 11th Year: 11.91, 11.68, 11.94, 11.92, 11.85, 11.90
  - Long run: 12.00 across all
- Net foreign assets to GDP:
  - Impact: -0.18, -0.13, -0.18, -0.18, -0.18, -0.19
  - 11th Year: -1.60, -0.68, -1.58, -1.61, -1.57, -1.59
  - Long run: -5.20, -5.83, -5.17, -5.30, -5.23, -5.19
- Real interest rate:
  - Impact: -0.04, 0.11, -0.01, -0.17, -0.07, -0.05
  - First 10 years (average): 0.12, 0.02, 0.15, 0.04, 0.07, 0.12
  - Long run: 0.97, 0.35, 1.15, 0.53, 0.79, 0.93
- Real exchange rate, Real GDP, Consumption, Investment (Tables 15):
  - Real exchange rate Impact: -0.62, -0.43, -0.62, -0.61, -0.60, -0.55
  - Real GDP Impact: 0.06, 0.04, 0.07, 0.03, 0.04, 0.06
  - Consumption Impact: 0.14, 0.14, 0.24, -0.24, -0.02, 0.14
  - Investment Impact: 0.68, 0.30, 0.33, 2.06, 1.22, 0.81
- Foreign economy responses (Table 16) show negative long-run impacts:
  - Real GDP Long run: -3.39, -1.18, -3.86, -1.86, -2.75, -3.33
  - Investment Long run: -8.97, -3.33, -10.37, -5.07, -7.37, -9.83
  - Real interest rate Long run: 0.97, 0.35, 1.15, 0.53, 0.79, 0.93

*Source: Box 2.2, World Economic Outlook, April (Washington, D.C.: International Monetary Fund).*

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