## Getting to Know GIMF: The Simulation Properties of the Global Integrated Monetary and Fiscal Model

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### Introduction
- Purpose: document simulation properties of IMF’s Global Integrated Monetary and Fiscal model (GIMF) and illustrate how the model’s theoretical structure translates into macroeconomic behavior.
- Focus variables: real GDP, inflation, interest rates, exchange rates, current account balances.
- Emphasis on: responses to shocks in the United States and spillovers to other regions.
- Organization: Section II summarizes GIMF; Sections III–VII explore fiscal, financial/monetary, demand, supply, and international shocks.

### Summary of the Global Integrated Monetary and Fiscal Model (GIMF)
- Model class and key features:
  - Multicountry Dynamic Stochastic General Equilibrium (DSGE) model with optimizing households and firms and full intertemporal stock-flow accounting.
  - Frictions: sticky prices and wages, real adjustment costs, liquidity-constrained households, finite-planning horizons.
  - Non-Ricardian features → fiscal non-neutrality: fiscal policy can stimulate short-run activity but sustained deficits crowd out private investment and net foreign assets in the long run.
  - Asset market incompleteness: government debt held domestically as nominal, non-contingent, one-period domestic-currency bonds; internationally traded assets are nominal, non-contingent, one-period U.S. dollar bonds.
  - Financial accelerator (Bernanke, Gertler and Gilchrist (1999)) → external finance cost rises with firm indebtedness; non-linearities produce steep risk-premium increases for large negative net worth shocks.
  - Uncovered interest parity does not hold due to country risk premiums.
- Regional structure and international linkages:
  - Version used: 5-region model — the United States, the euro area, Japan, emerging Asia (including China), and the remaining countries as a single entity.
  - All bilateral trade flows and relative prices, including exchange rates, explicitly modeled and calibrated to match recent steady-state flows.
  - Global saving and investment, driven by consumers’ finite horizons, determine current account balances and net foreign asset positions; net foreign assets represented by nominal U.S. dollar bonds.
- Fiscal sustainability:
  - Fiscal rule ensures long-run government debt-to-GDP and deficit-to-GDP ratios converge to targets; instruments include labor and capital income taxes (replaceable by other instruments regionally).

### Household Sector (Section II.A)
- Household types:
  - Overlapping-generation households (OLG) with a 20-year planning horizon who optimize borrowing and saving.
  - Liquidity-constrained households (LIQ) who do not save and have no access to credit; consumption = current net income (marginal propensity to consume = unity).
- Taxation: direct taxes on labor income, indirect consumption taxes, and a lump-sum tax apply to both household types.
- Key implications:
  - High proportion of LIQ households → large fiscal multipliers for temporary tax or transfer changes.
  - For OLG households, short-run positive output effects from tax cuts persist even when matched by future tax increases that stabilize long-run debt because future liabilities fall partially outside their planning horizon.
  - Increases in interest rates reduce consumption primarily via wealth effects; intertemporal substitution effect moderate and calibrated to empirical evidence.
  - Intertemporal elasticity of substitution pins down long-run crowding-out of private capital via required increases in real interest rates.

### Production Sector (Section II.B)
- Firms:
  - Produce tradable and nontradable intermediate goods; finite planning horizons → equity premium driven by impatience.
  - Face nominal price rigidities and real adjustment costs for labor hiring and investment.
  - Operate in monopolistically competitive markets with markups over marginal cost.
- Financing and bankruptcy:
  - Retained earnings insufficient to fully finance investment; firms borrow from financial intermediaries.
  - If earnings fall below required interest payments, intermediaries seize capital less auditing/bankruptcy costs and redistribute to depositors.
- Inputs and public capital:
  - Firms use government capital stock (public infrastructure) which augments productivity.
- Price/quantity features:
  - Exports priced to local destination markets; imports subject to quantity adjustment costs; price adjustment costs induce sticky prices.

### Financial Sector (Section II.C)
- Asset menu:
  - One-period domestic-currency government bonds, fixed-term household deposits; OLG households may issue/purchase tradable U.S.-dollar-denominated obligations.
  - Domestic financial assets and firm ownership non-tradable across borders.
- Intermediaries and spreads:
  - Banks pay market return on deposits and charge a lending rate including an external financing premium that increases with leverage (debt-to-equity ratio).
  - Bankruptcy costs and non-linearities produce steep risk-premium rises for large negative net worth shocks.
- International rates:
  - Country risk premiums generate deviations from uncovered interest parity and persistent cross-country interest rate differences after adjusting for expected exchange rate movements.

### International Dimensions and Spillovers (Section II.D)
- Trade and prices:
  - Explicit bilateral exports and imports for intermediate and final goods; calibrated to observed steady-state trade flows.
- Determinants of spillovers:
  - International linkages driven by global saving and investment and by world real interest rate movements; these and uncovered interest parity deviations determine spillover magnitude.

### Fiscal and Monetary Policy (Section II.E)
- Fiscal instruments:
  - Government spending as consumption or investment; lump-sum transfers to all households or targeted to LIQ households.
  - Revenues from labor and corporate income taxes, consumption taxes, lump-sum taxes, and tariffs.
  - Government investment augments public infrastructure and depreciates at a constant rate (public capital depreciation rate noted elsewhere as 4 percent).
- Fiscal rule and instruments:
  - Fiscal rule ensures long-run sustainability while permitting short-run countercyclical action.
  - Changes in labor and capital income taxes serve to implement the rule but can be replaced by other instruments.
  - Rule ensures eventual convergence of government debt-to-GDP and deficit-to-GDP ratios to target levels, excluding sovereign default and preventing financing requirements from overriding monetary policy.

### III. Properties of Fiscal Shocks — Two-Year Temporary Stimulus
- General setup:
  - Experiments: 1 percentage point of baseline GDP increase in a single fiscal instrument for two years; results reported as deviations from steady-state baseline.
  - Government adjusts general lumpsum transfers to maintain the deficit-to-GDP target in the long run.
- Two-year increase in government consumption (1 percentage point of baseline GDP for two years):
  - Real GDP rises by less than 1 percent for two years.
  - Inflation rises by more than ¼ percentage point.
  - U.S. monetary authority raises nominal policy interest rate → real interest rates increase → dampens private investment and partially offsets consumption increases.
  - Temporary deterioration in the current account via real effective exchange rate appreciation and higher imports.
- Two-year increase in government investment (1 percentage point of baseline GDP for two years):
  - Real GDP rises by just over 1 percent after two years.
  - Real GDP stays above baseline for over thirty years.
  - Inflation effects similar to government consumption case.
  - Distinguishing mechanism: government investment raises public capital stock; public capital depreciation rate = 4 percent versus private capital depreciation rate = 10 percent → productivity effect lasts much longer.
- Two-year increase in lumpsum transfers (1 percentage point of baseline GDP for two years):
  - U.S. population shares: OLG households 75%, LIQ households 25%.
  - General lumpsum transfers to all households → real GDP and inflation rise only marginally.
  - Transfers targeted to LIQ households → real GDP increases by just under ½ percent; inflation rises by less than ¼ percentage point.
  - Mechanism: LIQ households spend all current income; targeted transfers have larger immediate consumption effect; monetary response raises nominal and real rates, damping investment; fiscal multipliers below unity.
- Two-year decrease in taxation (1 percent of baseline GDP for 2 years via consumption, labor, or corporate income taxes):
  - Common outcomes: modest GDP growth of roughly ¼ percent; inflation rises only marginally under capital and consumption tax reductions; essentially unchanged under labor tax reduction.
  - Mechanisms vary:
    - Consumption tax cuts: directly lower consumer prices → higher private consumption for two years; slight CPI inflation increase.
    - Labor income tax cuts: raise labor supply and household income → consumption rises; marginal cost and inflation roughly unchanged.
    - Corporate income tax cuts: raise return on capital → more investment and private consumption; slight inflation acceleration; monetary authority slightly raises nominal policy rate.

### Box I — Impact of Monetary Accommodation on Fiscal Multipliers (exact figures)
- Monetary accommodation: monetary authority does not respond to fiscal stimulus while slack keeps inflation unlikely to exceed target.
- Fiscal multiplier = average deviation of real GDP from baseline during the two years of fiscal stimulus (stimulus = 1 percent of GDP increase in government surplus via one instrument).
- Accommodation increases multipliers; examples (Average GDP Impact after First Two Years, Percent Deviation from Baseline):
  - Gov’t. Consumption: No Accommodation 0.76; One Year of Accommodation 0.92; Two Years of Accommodation 1.43
  - Gov’t. Investment: No Accommodation 1.17; One Year of Accommodation 1.36; Two Years of Accommodation 1.89
  - General Transfers: No Accommodation 0.10; One Year of Accommodation 0.13; Two Years of Accommodation 0.24
  - Transfers to LIQ Households: No Accommodation 0.42; One Year of Accommodation 0.52; Two Years of Accommodation 0.86
  - Consumption Tax: No Accommodation 0.29; One Year of Accommodation 0.35; Two Years of Accommodation 0.56
  - Corporate Income Tax: No Accommodation 0.24; One Year of Accommodation 0.31; Two Years of Accommodation 0.52

### IV. Permanent Fiscal Consolidation (20 percentage point reduction in public debt-to-GDP)
- General scenario:
  - Achieve permanent 20 percentage point reduction in public debt-to-GDP by initially adjusting one fiscal instrument by 1 percent of baseline GDP; results are deviations from steady-state baseline.
  - Common dynamics: initial decline in activity and inflation; monetary easing (nominal policy rate cuts) lowers real interest rates and crowds in private investment over time; permanently lower public debt reduces global demand for savings → world real interest rate falls.
- Consolidation via government consumption (initial 1 percent of baseline GDP cut to achieve 20 percentage point debt reduction):
  - Real GDP initially declines by almost 1 percent then recovers and stabilizes slightly above baseline in the long run.
  - Inflation falls by almost ¼ percentage point before returning to baseline after five years.
  - Monetary authority cuts nominal policy interest rate; lower real rates crowd in private investment.
- Consolidation via government investment:
  - Real GDP decreases by similar 1 percent initially, then declines for an extended period before stabilizing slightly above baseline in the long run.
  - Inflation falls by almost ½ percentage point before returning close to baseline after 10 years.
  - Mechanism: reduced government investment lowers public capital (public capital depreciation rate = 4 percent) → large negative productivity shock with longer-lasting GDP impact.
- Consolidation via lumpsum transfer cuts (initial 1 percent of baseline GDP):
  - Real GDP falls marginally in first year, then begins to rise; long-run real GDP increases by under ¼ percent in both general and LIQ-targeted cases.
  - Targeted cuts to LIQ: immediate LIQ consumption fall by full amount; monetary authority decreases nominal interest rates → lower real rates crowd in private investment; long-run transfers as a share of GDP roughly ¼ percentage point higher than baseline due to lower interest payments and gradual reversal of cuts.
  - Exchange rate: initial U.S. real effective exchange rate depreciation raises import prices and lowers U.S. export prices abroad; long-run appreciation as net foreign asset position improves.

### V. Credibility, the Zero Interest Rate Floor (ZIF), and Consolidation Timing
- Credibility scenarios for a permanent 1 percentage point of GDP improvement in government surplus (20 percentage points lower debt-to-GDP):
  1. Immediately credible.
  2. Credible in one year.
  3. Credible in two years.
- If agents do not perceive consolidation as credible, they assume change lasts one year then returns to previous fiscal stance.
- Fully credible outcomes:
  - Real GDP falls immediately; downward pressure on inflation → lower nominal and real rates; private consumption and investment strengthen after initial fall; long-run U.S. real GDP increases by ½ percent relative to baseline.
  - Global spillovers: real GDP permanently higher everywhere due to lower world real interest rate; global re-equilibration of current accounts.
- Delayed credibility:
  - If agents delay belief, short-run real GDP falls further; the longer the delay, the larger the additional fall.
- Interaction with ZIF (selected exact entries from Table 2: Government Consumption Multipliers — Real GDP in the United States, Percent Deviation from Baseline):
  - Credible Immediately, No ZIF: Year 1 -0.71; Year 2 -0.35; Year 3 -0.16; Year 4 -0.06; Year 5 -0.05; Long Run 0.23
  - Credible Immediately, 1-Year ZIF: Year 1 -0.87; Year 2 -0.56; Year 3 -0.16; Year 4 -0.01; Year 5 -0.01; Long Run 0.23
  - Credible Immediately, 2-Year ZIF: Year 1 -1.57; Year 2 -1.28; Year 3 -0.62; Year 4 0.19; Year 5 0.24; Long Run 0.23
  - Credible in Year 2, No ZIF: Year 1 -0.88; Year 2 -0.63; Year 3 -0.25; Year 4 -0.09; Year 5 -0.03; Long Run 0.23
  - Credible in Year 2, 1-Year ZIF: Year 1 -1.03; Year 2 -0.82; Year 3 -0.25; Year 4 -0.04; Year 5 0.00; Long Run 0.23
  - Credible in Year 2, 2-Year ZIF: Year 1 -1.56; Year 2 -1.53; Year 3 -0.80; Year 4 0.11; Year 5 0.24; Long Run 0.23
  - Credible in Year 3, No ZIF: Year 1 -0.88; Year 2 -0.81; Year 3 -0.54; Year 4 -0.19; Year 5 -0.06; Long Run 0.23
  - Credible in Year 3, 1-Year ZIF: Year 1 -1.03; Year 2 -1.28; Year 3 -0.46; Year 4 -0.07; Year 5 0.03; Long Run 0.23
  - Credible in Year 3, 2-Year ZIF: Year 1 -1.56; Year 2 -2.01; Year 3 -1.03; Year 4 0.08; Year 5 0.28; Long Run 0.23
- ZIF key observations:
  - If ZIF binds, monetary easing benefits are absent → further decline in real GDP; longer ZIF binding → larger fall.
  - ZIF effect magnified when households doubt government commitment, with one noted exception in year-one effects when ZIF binds for two years and consolidation is fully credible.

### VI. Financial and Monetary Shock Properties
- Temporary increase in the nominal policy interest rate:
  - Experiment: one-year, 100 basis point increase in U.S. nominal policy interest rate.
  - On impact: U.S. GDP decreases by almost ¾ percent; inflation decreases by almost ½ percentage point at trough in year two.
  - Mechanisms: higher real rates reduce investment and consumption; dollar appreciation lowers import prices and raises export prices abroad; slight short-run current account deterioration.
  - Fiscal response: automatic stabilizers increase deficit; debt-service costs rise; transfers later reduced to return public debt-to-GDP to target.
  - International spillovers: transmitted mainly through trade linkages and relatively small.
- Temporary but persistent increase in borrowers’ riskiness:
  - Experiment: corporate financing premium rises by 1 percentage point on impact; persistence: declines by roughly half every 2 years.
  - On impact: real GDP declines by approximately ½ percent; inflation falls by less than ¼ percentage point.
  - Mechanisms: higher borrowing costs reduce investment and profits → lower dividends and household wealth → consumption falls less than investment.
  - Monetary authority decreases policy interest rate to stimulate demand; small real depreciation increases exports and decreases imports; current account improves modestly.
  - Fiscal impact: minor via automatic stabilizers.

### Box II & IV — Financial Accelerator and Leverage
- GIMF incorporates the BGG financial accelerator.
- Effects with accelerator:
  - Higher output and profits and small reduction in real value of firms' debt increase firm net worth → external financing premium falls → offsets some higher monetary policy cost of capital.
  - For sustained productivity increases, profitability increases net worth; inflation effects small.
- Box III leverage experiment (steady-state corporate debt/net worth ratios):
  - Leverage ratios tested: 1 (baseline), 1.75, 2.5.
  - Higher steady-state leverage raises bankruptcy cutoff and probability of default for a given risk increase.
  - Rise in external finance premia larger when leverage higher; investment and real interest rate more volatile under higher leverage.

### VII. Properties of Demand Shocks
- Temporary increase in private domestic demand:
  - Shock: one-year, 1 percentage point increase in private consumption; one-year, 4 percentage point increase in private investment.
  - U.S. outcomes: short-run GDP increases by just over 1 percent; inflation rises by less than ¼ percentage point.
  - Higher investment raises persistent private capital stock → persistent output increase.
  - Monetary authority raises policy rate; fiscal authority reduces general transfers countercyclically.
  - Exchange rate: real effective exchange rate appreciates → import prices fall, export prices rise → trade balance reduced.
  - Rest of world: real GDP initially expands by roughly one-seventh the U.S. increase.
- Permanent increase in saving (OLG households increase saving by 1 percentage point permanently):
  - Short-run: real GDP decreases in first year by less than ¼ percent.
  - Long-run: model reports both "almost ¼ percent" and later "almost ½ percent" increases in real GDP (text reports these two long-run figures).
  - Inflation declines initially then takes years to return to target; firms reduce labor demand; rental rate of capital falls.
  - Monetary authority reduces policy rate; equilibrium interest rate falls; lower user cost of capital stimulates investment; higher capital stock yields permanently higher output and income.
  - External: short-run real effective exchange rate depreciation improves trade balance; long-run real effective exchange rate appreciates given higher foreign assets.
  - Rest of world: initial reduction in foreign real GDP and small inflation decline; long-run foreign real GDP rises due to lower global real interest rate.

### VIII. Properties of Supply Shocks
- Permanent increase in level of labor-augmenting productivity (1 percent economy-wide or calibrated tradable-only):
  - Higher marginal products → higher real wages and rental rates → large increase in household income and private demand.
  - Marginal costs decline → firms lower output prices; monetary authority lowers policy rate; investment increases; fiscal transfers reduced temporarily.
  - Real effective exchange rate effects:
    - Economy-wide productivity rise → real effective exchange rate depreciates to sell additional output abroad.
    - Tradable-only productivity rise → Balassa-Samuelson effect can produce real effective exchange rate appreciation depending on relative-price and wage responses.
  - Long run: current account shifts to small deficit; net foreign assets decline as domestic saving insufficient to finance higher capital stock.
  - Rest of world: spillovers to foreign productivity; small upward pressure on world real interest rate; foreign real GDP increases.
- Temporary 10-year increase in productivity growth (calibrated to raise annual GDP by just under ¼ percent; cumulative ~2 percent after ten years):
  - Anticipated vs unanticipated:
    - Unanticipated: marginal cost decline dominates → short-run inflation falls slightly.
    - Anticipated: households increase current spending → demand effect raises short-run inflation by less than ¼ percentage point; monetary authority raises policy rate.
  - Anticipated case: higher real interest rate and currency appreciation → import prices fall, export prices rise → trade balance and current account worsen in short run.
  - Long run: real effective exchange rate depreciates to absorb higher U.S. output.
- Permanent increase in labor market competition (wage markup down by five percentage points):
  - Short run: mild disinflationary pressure.
  - Long run: real GDP increases almost 1½ percent above baseline.
  - Mechanisms: lower wage markup reduces producer–household wedge → firms employ more labor and capital; higher labor income raises human wealth → higher saving and consumption → permanently higher real GDP; lower marginal production costs → mild decline in inflation.

### IX. Competition, Markups, and the Exchange Rate
- Permanent decrease in intermediate goods markups by five percentage points:
  - Real GDP rise: roughly 2 or 3 percent in the long run depending on which sector experiences the markup decline.
  - Tradable sector competition → real GDP rises to 2 percent above baseline over ten years.
  - Nontradable sector competition → real GDP rises to 3 percent above baseline over ten years.
  - CPI inflation may rise slightly along the adjustment path (peak in year 5 at approximately ¼ percentage point) despite sectoral disinflation.
  - Real interest rate: short-run upward pressure as investment demand outpaces saving; long run small reduction as higher income raises saving more than investment demand.
  - Real effective exchange rate: appreciation in tradable-sector competition case; depreciation in nontradable-sector competition case.

### X. Properties of International Shocks
- Temporary increase in sovereign risk (100 basis points):
  - Shock: temporary but persistent 100 basis point increase in risk premia on sovereign/dollar assets.
  - Macroe impacts: real GDP falls by just over ¼ percent; inflation falls more modestly; dollar depreciates by almost 1½ percent.
  - Mechanisms: higher real interest rates raise user cost of capital → investment and wealth fall; firms scale back production and labor demand; tradable-sector employment may rise short run due to depreciation; consumption falls.
  - Monetary/fiscal: monetary authority lowers nominal policy rate but market rates remain elevated; fiscal deficit rises due to higher debt-service costs and is later restored by lowering general transfers.
  - Current account: improves in short run via depreciation and lower imports.
- Permanent increase in tariffs (ten percentage points on imports from all regions):
  - Macroe impacts: permanent decrease in real GDP of around 1 percent; inflation increases marginally short run, then returns to baseline.
  - Distribution: tariff revenue redistributed to households via transfers → private consumption increases.
  - Trade: import volumes fall; real appreciation moderates foreign demand for U.S. goods.
  - Investment: long-run business investment declines due to lower final goods demand.
  - Current account: net impact small with tiny permanent deterioration.
  - International: rest-of-world real GDP declines roughly the same amount as U.S. when adjusted for relative sizes; effects abroad roughly 1/3 the size of U.S. effects given rest of world ~ three times larger than the United States.

*Source: IMF Working Paper WP/13/55, "Getting to Know GIMF: The Simulation Properties of the Global Integrated Monetary and Fiscal Model" (February 2013).*

### Section 1

### Getting to Know GIMF: The Simulation Properties of the Global Integrated Monetary and Fiscal Model

### Introduction
- Purpose: Document the simulation properties of the IMF's Global Integrated Monetary and Fiscal model (GIMF) and illustrate how the model’s theoretical structure translates into macroeconomic behavior.
- Focus variables: real GDP, inflation, interest rates, exchange rates, current account balances.
- Emphasis on: responses to shocks in the United States and spillovers to other regions; properties generally hold across regions with region-specific differences (e.g., share of liquidity-constrained households, fixed nominal exchange rates).
- Organization: Section II summarizes GIMF; Sections III–VII explore fiscal, financial/monetary, demand, supply, and international shocks.

### Summary of the Global Integrated Monetary and Fiscal Model (GIMF)
- Model class and features:
  - Multicountry Dynamic Stochastic General Equilibrium (DSGE) model with optimizing households and firms and full intertemporal stock-flow accounting.
  - Frictions: sticky prices and wages, real adjustment costs, liquidity-constrained households, finite-planning horizons.
  - Non-Ricardian features generate non-neutrality of fiscal measures; fiscal policy can stimulate short-run activity but sustained deficits crowd out private investment and net foreign assets in the long run.
  - Asset market incompleteness: government debt held domestically as nominal, non-contingent, one-period domestic-currency bonds; internationally traded assets are nominal, non-contingent, one-period U.S. dollar bonds issued by the U.S. government and private agents.
  - Financial accelerator a la Bernanke, Gertler and Gilchrist (1999): cost of external finance rises with firm indebtedness; non-linearities yield steep increases in risk premia for large negative net worth shocks.
  - Uncovered interest parity does not hold due to country risk premiums.
- Regional structure and international linkages:
  - Version used: 5-region model — the United States, the euro area, Japan, emerging Asia (including China), and the remaining countries as a single entity.
  - All bilateral trade flows and relative prices, including exchange rates, are explicitly modeled and calibrated to match recent steady-state flows.
  - Global saving and investment decisions, driven by consumers’ finite horizons, determine current account balances and net foreign asset positions; net foreign assets represented by nominal U.S. dollar bonds.
- Fiscal sustainability:
  - Fiscal rule ensures long-run government debt-to-GDP and deficit-to-GDP ratios converge to targets, excluding sovereign default and overwhelming monetary policy; instruments include labor and capital income taxes (replaceable by other tax/transfer/spending instruments if regionally appropriate).

### Household Sector (Section II.A)
- Household types:
  - Overlapping-generation households (OLG) with a 20-year planning horizon who optimize borrowing and saving.
  - Liquidity-constrained households (LIQ) who do not save and have no access to credit; consumption equals current net income (marginal propensity to consume = unity).
- Taxation: direct taxes on labor income, indirect consumption taxes, and a lump-sum tax apply to both household types.
- Key implications:
  - High proportion of LIQ households implies large fiscal multipliers for temporary tax or transfer changes.
  - For OLG households, short-run positive output effects from tax cuts persist even when matched by future tax increases that stabilize long-run debt, because future liabilities fall partially outside their planning horizon.
  - Increases in interest rates reduce consumption primarily via wealth effects; intertemporal substitution effect is moderate and calibrated to empirical evidence.
  - The intertemporal elasticity of substitution pins down long-run crowding-out of private capital via required increases in real interest rates.

### Production Sector (Section II.B)
- Firms:
  - Produce tradable and nontradable intermediate goods; managed according to the preferences of finitely-lived household owners (finite planning horizons → equity premium driven by impatience).
  - Face nominal price rigidities and real adjustment costs for labor hiring and investment.
  - Operate in monopolistically competitive markets with markups over marginal cost.
- Financing and bankruptcy:
  - Retained earnings insufficient to fully finance investment; firms borrow from financial intermediaries.
  - If earnings fall below required interest payments, intermediaries seize capital less auditing/bankruptcy costs and redistribute it to depositors.
- Inputs and public capital:
  - Firms use public infrastructure (government capital stock) along with intermediate goods; government capital augments productivity.
- Price/quantity features:
  - Exports priced to local destination markets; imports subject to quantity adjustment costs; price adjustment costs induce sticky prices.

### Financial Sector (Section II.C)
- Asset menu:
  - Limited set: one-period domestic-currency government bonds, fixed-term household deposits; OLG households may issue/purchase tradable U.S.-dollar-denominated obligations.
  - Domestic financial assets and firm ownership are non-tradable across borders.
- Intermediaries and spreads:
  - Banks pay market return on deposits and charge a lending rate including an external financing premium that increases with leverage (debt-to-equity ratio).
  - Bankruptcy costs and non-linearities produce steep risk-premium rises for large negative net worth shocks.
- International rates:
  - Country risk premiums generate deviations from uncovered interest parity and persistent cross-country interest rate differences after adjusting for expected exchange rate movements.

### International Dimensions and Spillovers (Section II.D)
- Trade and prices:
  - Explicit modeling of all bilateral exports and imports of intermediate and final goods and relative prices.
  - Calibrated to observed steady-state trade flows.
- Determinants of spillovers:
  - International linkages driven by global saving and investment and by world real interest rate movements; these along with uncovered interest parity deviations determine spillover magnitude.

### Fiscal and Monetary Policy (Section II.E)
- Fiscal instruments:
  - Government spending as consumption or investment; lump-sum transfers to all households or targeted to LIQ households.
  - Revenues from labor and corporate income taxes, consumption taxes, lump-sum taxes, and tariffs.
  - Government investment augments public infrastructure and depreciates at a constant rate.
- Fiscal rule and instruments:
  - Fiscal policy rule ensures long-run sustainability while permitting short-run countercyclical action.
  - Changes in labor and capital income taxes serve to implement the rule but can be replaced by other instruments.
  - Rule ensures eventual convergence of government debt-to-GDP and deficit-to-GDP ratios to target levels, excluding sovereign default and preventing financing requirements from overriding monetary policy.

*Source: IMF Working Paper WP/13/55, "Getting to Know GIMF: The Simulation Properties of the Global Integrated Monetary and Fiscal Model" (February 2013).*

### Section 2

### _wp1355 - Section 2

### III. PROPERTIES OF FISCAL SHOCKS
- GIMF examines seven fiscal instruments: government consumption spending, government investment spending, general lumpsum transfers to all households, lumpsum transfers targeted to high-marginal-propensity-to-consume LIQ households, consumption taxes, labor income taxes, and corporate income taxes.
- Simulation experiments are conducted in the United States block of the model.
- Scenarios considered: temporary fiscal stimulus, permanent fiscal consolidation, and fiscal consolidation that accounts for the credibility of fiscal policy.
- All reported results are deviations from the steady-state baseline.
- To maintain the deficit-to-GDP target in the long run, the government adjusts general lumpsum transfers.

### Fiscal Multipliers Based on 2 Years of Fiscal Stimulus
- Experiments: a 1 percentage point of baseline GDP increase in a single fiscal instrument for two years.
- Amplifying effects of monetary accommodation are summarized separately (Box I).
- Results shown as deviations from steady-state baseline; rest-of-world effects are small for temporary stimulus and discussed only for permanent stimulus thereafter.

### Two Year Increase in Government Spending – Consumption versus Investment
- A 1 percentage point of baseline GDP increase in government consumption for two years:
  - Real GDP rises by less than 1 percent for two years.
  - Inflation rises by more than ¼ percentage point.
- A 1 percentage point of baseline GDP increase in government investment for two years:
  - Real GDP rises by just over 1 percent after two years.
  - Real GDP stays above baseline for over thirty years.
  - Inflation effects similar to government consumption case.
- Mechanisms and transmission:
  - Higher government spending increases aggregate demand directly; government goods have domestic and imported components.
  - Increased demand for domestic final goods raises demand for domestic labor, wages, marginal costs, and prices of domestically produced goods.
  - U.S. monetary authority raises the nominal policy interest rate in response to rising inflation, raising real interest rates and increasing the cost of capital, which dampens private investment.
  - Higher real interest rates partially offset higher household incomes on consumption.
  - Automatic fiscal stabilizers adjust transfers to dampen private demand.
  - Real interest rate increase appreciates the U.S. real effective exchange rate, lowering import prices, increasing imports, and reducing foreign demand for U.S. exports → temporary deterioration in the current account.
- Distinguishing feature of government investment:
  - Government investment raises public capital stock, increasing general productivity and real GDP.
  - Government capital has depreciation rate 4 percent versus private capital depreciation rate 10 percent, so the productivity effect lasts much longer.

### Two Year Increase in Lumpsum Transfers – General versus Targeted to LIQ Households
- Experiment: 1 percentage point of baseline GDP increase in lumpsum transfers for two years.
- Population shares in United States: OLG households 75%, LIQ households 25%.
- General lumpsum transfers to all households:
  - Real GDP and inflation rise only marginally.
- Targeted lumpsum transfers to LIQ households:
  - Real GDP increases by just under ½ percent.
  - Inflation rises by less than ¼ percentage point.
- Mechanisms:
  - Transfers affect aggregate demand indirectly through household incomes.
  - LIQ households spend all current income, so transfers to LIQ cause large immediate private consumption increases.
  - Monetary response: U.S. monetary authority raises nominal interest rate; higher real rates dampen private investment and offset consumption increases.
  - Automatic fiscal stabilizers operate to dampen private demand.
  - Net result: fiscal multiplier below unity.
  - Exchange rate channel: higher real interest rates appreciate real effective exchange rate → lower import prices, higher imports, reduced exports → temporary current account deterioration.
- When transfers are split across household types:
  - Effects are qualitatively similar but much smaller because OLG households smooth consumption via capital markets.

### Two Year Decrease in Taxation
- Experiment: decrease taxation by 1 percent of baseline GDP for 2 years using one of: consumption taxes, labor income taxes, or corporate income taxes.
- Common outcomes:
  - All three tax cuts produce modest GDP growth of roughly ¼ percent.
  - Inflation rises only marginally under reductions in capital and consumption taxes; essentially unchanged under reduction in labor taxes.
  - Higher real interest rates (via monetary response) lead to appreciation of the U.S. real effective exchange rate, lowering import prices, increasing imports, and contributing to automatic stabilizer responses (transfers decline) → fiscal multipliers well below unity.
- Instrument-specific transmission:
  - Consumption tax cuts:
    - Directly decrease price households pay for consumption goods → higher private consumption for two years.
    - Raises demand for labor, wages, marginal cost, and slightly increases CPI inflation (CPI excludes indirect taxes).
  - Labor income tax cuts:
    - Raise labor supply; higher household incomes and labor effort increase consumption.
    - Increased aggregate demand offsets downward pressure on wages → marginal cost and inflation roughly unchanged.
  - Corporate income tax cuts:
    - Raise return on capital → increases household income, induces firms to invest more, and boosts private consumption.
    - Stronger private demand increases labor demand, marginal cost, and pre-tax prices → slight inflation acceleration.
    - Monetary authority slightly raises nominal policy rate → higher real interest rate dampens private investment and offsets higher household incomes on consumption.

### Box I: The Impact on Fiscal Multipliers of Monetary Accommodation
- Monetary accommodation: periods when monetary authority does not respond to fiscal stimulus because slack makes inflation unlikely to exceed target.
- Fiscal multiplier defined as the average deviation of real GDP from baseline during the two years of fiscal stimulus.
- Stimulus: 1 percent of GDP increase in the government surplus (achieved by changing one fiscal instrument).
- Monetary accommodation lowers real interest rates relative to a responsive policy, magnifying fiscal multipliers; the longer the accommodation, the larger the multiplier increase.
- Example: one year of accommodation with government consumption stimulus yields an additional ¼ percent of real GDP on average during the two years; two years of accommodation yields an additional ½ percent on average.
- Table 1: Fiscal Multipliers with Monetary Accommodation, Average GDP Impact after First Two Years (Percent Deviation from Baseline)
  - Gov’t. Consumption: No Accommodation 0.76; One Year of Accommodation 0.92; Two Years of Accommodation 1.43
  - Gov’t. Investment: No Accommodation 1.17; One Year of Accommodation 1.36; Two Years of Accommodation 1.89
  - General Transfers: No Accommodation 0.10; One Year of Accommodation 0.13; Two Years of Accommodation 0.24
  - Transfers to LIQ Households: No Accommodation 0.42; One Year of Accommodation 0.52; Two Years of Accommodation 0.86
  - Consumption Tax: No Accommodation 0.29; One Year of Accommodation 0.35; Two Years of Accommodation 0.56
  - Corporate Income Tax: No Accommodation 0.24; One Year of Accommodation 0.31; Two Years of Accommodation 0.52

### B. Permanent Fiscal Consolidation
- Scenario: permanent reduction in government debt by adjusting one fiscal instrument; results are deviations from steady-state baseline.
- Common dynamics:
  - Permanent consolidation typically leads to an initial decline in activity and inflation, monetary easing (nominal policy rate cuts) that lowers real interest rates, which crowds in private investment over time.
  - Permanently lower public debt reduces global demand for savings → world real interest rate falls → private investment increases.
  - Exchange rate responses: short-run depreciation of U.S. real effective exchange rate (from lower real interest rates) raises import prices and lowers U.S. export prices abroad; long-run appreciation as net foreign liabilities improve.

### Permanent Fiscal Consolidation through Government Spending – Consumption versus Investment
- Experiment: achieve a permanent 20 percentage point reduction in the ratio of public debt to GDP by initially reducing public expenditures by 1 percent of baseline GDP.
- Consolidation via government consumption spending:
  - Real GDP initially declines by almost 1 percent before recovering and stabilizing slightly above baseline in the long run.
  - Inflation falls by almost ¼ percentage point before returning to baseline levels after five years.
  - Monetary authority cuts nominal policy interest rate in response to disinflation → lower real interest rates crowd in private investment.
  - Lower interest payments allow gradual reversal of consumption cuts; public consumption can rise above previous baseline in long run.
  - Households increase consumption and leisure; labor supply declines.
- Consolidation via government investment spending:
  - Real GDP decreases by a similar 1 percent in the first period, then declines for an extended period before stabilizing slightly above baseline in the long run.
  - Inflation falls by almost ½ percentage point before returning close to baseline levels after 10 years.
  - Mechanism: fall in government investment reduces public capital stock (government capital depreciation rate 4 percent), acting as a large negative productivity shock and undermining capacity; longer-lasting negative impact on real GDP than consumption cut.
- Rest of world effects (Figure 6 summary):
  - Short run: cheaper U.S. goods and deteriorating trade balance lead foreign monetary authorities to cut nominal policy interest rates.
  - Long run: lower world real interest rate stimulates private investment in foreign economies; foreign current accounts fall with trade balance; real GDP increases in the long run owing to lower world real interest rates.

### Permanent Fiscal Consolidation through Lumpsum Transfers - General versus Targeted to LIQ Households
- Experiment: achieve a permanent 20 percentage point reduction in debt-to-GDP by initially reducing public lumpsum transfers by 1 percent of baseline GDP, either to all households (general) or only LIQ households (targeted).
- Outcomes:
  - Real GDP falls marginally in the first year, then begins to rise.
  - In the long run, real GDP increases by under ¼ percent in both cases.
  - Inflation falls slightly before returning to baseline.
- Targeted transfers to LIQ households:
  - LIQ consumption falls immediately by the full amount of the transfer decline → reduced aggregate demand and disinflation.
  - Monetary authority decreases nominal interest rates → lower real rates lower cost of capital and increase private investment.
  - Lower interest rates reduce private saving and stimulate private consumption, partially offsetting the transfer cut.
  - Permanently lower public debt lowers global real interest rate → crowds in private investment → real GDP above baseline in long run.
  - Lower interest payments allow government to gradually undo transfer cuts; in the long run transfers as a share of GDP are roughly ¼ percentage point higher than in the baseline.
  - U.S. real effective exchange rate depreciates initially, raising import prices and lowering U.S. export prices abroad; with increased saving, U.S. net foreign asset position and current account improve in the new steady state and real effective exchange rate appreciates.
- When transfers are cut to both OLG and LIQ households, the initial negative impact on activity is muted.

*Source: _wp1355 - Section 2 (PDF chapter).*

### Section 3

### Section 3

### Fiscal consolidation via transfer cuts (heterogeneous household impact)
- LIQ households experience a smaller decrease in their income, as 75% of the cut in transfers falls on OLG households, based on their population share.
- OLG households smooth consumption by using their savings, so the decline in aggregate GDP is less pronounced.
- All households become less wealthy in the near term and increase labor supply, lowering the real wage and marginal cost of domestic production; prices of domestic goods fall.
- Monetary policy and external-sector effects are qualitatively similar but muted relative to the case where only LIQ agents’ transfers are initially cut.
- Global effects:
  - Short run: downward pressure on inflation from cheaper U.S. goods and a deteriorating trade balance prompt foreign monetary authorities to cut nominal policy interest rates.
  - Long run: with a lower U.S. public debt-to-GDP ratio, world real interest rates fall, stimulating private investment in foreign economies.
  - Foreign current accounts fall with trade balances; long-run real GDP increases due to lower world real interest rates.

### Permanent fiscal consolidation through increased taxation (20 percentage point public debt reduction)
- Experiment: U.S. achieves a permanent 20 percentage point reduction in the ratio of public debt to GDP by initially increasing taxation by 1 percent of baseline GDP using one of three tax rates: consumption taxes, labor income taxes, or corporate income taxes.
- Long-run common mechanism: lower global real interest rates and taxes; permanent reduction in U.S. debt-to-GDP increases global savings, leading to a fall in global real interest rates of roughly 10 basis points in the long run.
- Fiscal dynamics: lower interest rates and less government debt reduce debt-service costs, allowing the government eventually to more than reverse the initial tax increase.
- Short-run real GDP impacts (by tax instrument):
  - Corporate income tax increase: real GDP drops the most, over ½ percent.
  - Labor income tax increase: real GDP drops roughly ½ percent.
  - Consumption tax increase: real GDP drops around ¼ percent.
- Long-run real GDP: will be above baseline as the fiscal authority can unwind the initial tax increase and provide a small tax cut; ordering of positive effects on real GDP in the long run:
  1. Cut in corporate income taxes (greatest positive effect)
  2. Labor income taxes
  3. Consumption taxes
- Inflation: initially falls for all three tax increases; the decline is notably larger when corporate income tax is increased due to the largest negative near-term demand impact.
- Monetary response: U.S. monetary authority cuts nominal policy interest rate in response to lower inflation, transmitting to real interest rates in the short run before long-run debt effects lower rates permanently.
- Distributional/sectoral effects:
  - Consumption and labor income tax hikes primarily affect households (consumption immediately declines under consumption tax; private saving falls; households work less).
  - Labor income tax hikes cause larger labor supply reductions than consumption tax hikes, raising firms’ labor costs and leading to a larger output decline.
  - Corporate income tax hikes primarily affect firms, causing a larger drop in investment due to a sharp decline in the return to capital; the decline in investment is long-lived, depressing productive capacity and leaving real GDP lower in the medium term despite lower real interest rates.
- External sector and exchange rate:
  - U.S. real effective exchange rate depreciates in response to the fall in real interest rates.
  - Import prices for U.S. residents rise; U.S. export prices fall abroad, increasing foreign demand for U.S. exports and decreasing domestic demand for imports.
  - U.S. net foreign asset position and current account balance improve in the new steady state and the real effective exchange rate appreciates.
- Global spillovers (Figure 10 summary):
  - Short run: foreign monetary authorities cut nominal policy interest rates due to downward pressure on inflation from cheaper U.S. goods and the deteriorating trade balance.
  - Long run: world real interest rates fall; both short- and long-run interest rate declines stimulate private investment in foreign economies.
  - Foreign current accounts fall with the trade balance; long-run real GDP increases owing to lower world real interest rates.

### Permanent fiscal consolidation and credibility
- Policy experiment: reduction in government consumption to generate a permanent improvement in the government surplus by 1 percentage point of GDP (government debt 20 percentage points lower in the long run).
- Credibility scenarios for when households/firms believe announced consolidation will be implemented:
  1. Immediately credible (agents immediately believe all announced future policy will be implemented).
  2. Credible in one year (takes one year before agents believe announced future policies will be implemented).
  3. Credible in two years (takes two years before agents believe announced future policies will be implemented).
- If agents do not perceive consolidation as credible, they assume the announced change will only last one year, followed by a permanent return to the previous fiscal stance.
- Fully credible case (recall Figure 5):
  - Real GDP falls immediately with the decrease in government spending; the government surplus rises.
  - Downward pressure on inflation leads to lower nominal and real interest rates; private consumption and investment begin to strengthen after falling in the first year.
  - Long run: fiscal consolidation increases aggregate saving supply in the U.S. and the world, leading to a permanent fall in the equilibrium world real interest rate.
  - Private saving decreases (not enough to offset public saving increase); private investment increases, raising productive capacity.
  - U.S. real GDP increases by ½ percent relative to baseline in the long run.
  - Global spillovers: real GDP permanently higher everywhere due to lower world real interest rate; global re-equilibration of current accounts (global increase in investment, global decrease in private saving, increase in U.S. government saving).
- Short-run impacts vary with delayed belief (Figure 11):
  - When households do not believe future consolidation will occur, they do not anticipate a permanent fall in interest rates and thus do not shift into consumption from private saving; only consumption increase comes from monetary easing.
  - Firms do not increase investment beyond the monetary-policy response.
  - Real GDP falls further than under full credibility; the fall is more severe the longer it takes for households to believe consolidation will occur.
- Interaction with the zero nominal interest rate floor (ZIF):
  - If ZIF binds, monetary policy easing is constrained; weaker aggregate demand reduces inflation and real interest rates will rise, further dampening aggregate demand.
  - Table 2 (Government Consumption Multipliers with Varying Assumptions) — Real GDP in the United States (Percent Deviation from Baseline), selected entries (preserve exact figures):
    - Credible Immediately, No ZIF: Year 1 -0.71; Year 2 -0.35; Year 3 -0.16; Year 4 -0.06; Year 5 -0.05; Long Run 0.23
    - Credible Immediately, 1-Year ZIF: Year 1 -0.87; Year 2 -0.56; Year 3 -0.16; Year 4 -0.01; Year 5 -0.01; Long Run 0.23
    - Credible Immediately, 2-Year ZIF: Year 1 -1.57; Year 2 -1.28; Year 3 -0.62; Year 4 0.19; Year 5 0.24; Long Run 0.23
    - Credible in Year 2, No ZIF: Year 1 -0.88; Year 2 -0.63; Year 3 -0.25; Year 4 -0.09; Year 5 -0.03; Long Run 0.23
    - Credible in Year 2, 1-Year ZIF: Year 1 -1.03; Year 2 -0.82; Year 3 -0.25; Year 4 -0.04; Year 5 0.00; Long Run 0.23
    - Credible in Year 2, 2-Year ZIF: Year 1 -1.56; Year 2 -1.53; Year 3 -0.80; Year 4 0.11; Year 5 0.24; Long Run 0.23
    - Credible in Year 3, No ZIF: Year 1 -0.88; Year 2 -0.81; Year 3 -0.54; Year 4 -0.19; Year 5 -0.06; Long Run 0.23
    - Credible in Year 3, 1-Year ZIF: Year 1 -1.03; Year 2 -1.28; Year 3 -0.46; Year 4 -0.07; Year 5 0.03; Long Run 0.23
    - Credible in Year 3, 2-Year ZIF: Year 1 -1.56; Year 2 -2.01; Year 3 -1.03; Year 4 0.08; Year 5 0.28; Long Run 0.23
  - Key ZIF observations:
    - If ZIF is binding, the positive effects from monetary policy easing are absent, resulting in a further decline in real GDP; the longer ZIF binds, the larger the fall in real GDP.
    - With one exception, the ZIF effect is magnified when households do not fully believe the government’s commitment to the announced fiscal plan.
    - In the first year with ZIF binding for two years, the GDP effect is largest when there is no uncertainty about the government’s commitment to the future consolidation path, because believing the consolidation is permanent implies prolonged weakness and lower expected inflation in year two, raising the current real interest rate and further depressing aggregate demand in year one.

### Properties of financial and monetary shocks
- Section overview: effects of shocks to U.S. monetary policy and the financial sector, and spillovers to the rest of the world where applicable. Monetary policy shock is a temporary increase in the monetary policy rate; financial shock is an increase in borrower riskiness. The Bernanke-Gertler-Gilchrist (BGG) financial accelerator is explored in two boxes.

A. Temporary increase in the nominal interest rate
- Experiment: one-year, 100 basis point increase in the U.S. nominal policy interest rate (Figure 12).
- On impact:
  - U.S. GDP decreases by almost ¾ percent.
  - Inflation decreases by almost ½ percentage point at its trough in the second year.
- Mechanisms:
  - Higher real interest rates reduce private investment and household consumption; business investment declines due to higher user cost of capital, lowering profitability, dividends, and household wealth.
  - Reduced production decreases labor demand, lowering employment and wages; fall in labor income and wealth reduces consumption.
  - Higher real interest rates appreciate the U.S. dollar, reducing import prices for U.S. residents and raising U.S. export prices abroad, leading to some expenditure switching away from domestic goods and lower foreign demand for U.S. exports; slight short-run deterioration in the U.S. current account.
  - Lower marginal costs and output prices reduce domestic price inflation; lower import prices add downward pressure on inflation.
- Fiscal response: automatic stabilizers increase the deficit in the short run; increased debt-service costs add to the deficit; eventually fiscal authority reduces general transfers to return public debt-to-GDP to target.
- Monetary response: after tightening, monetary policy eases to return inflation to target, reducing nominal interest rates and temporarily stimulating aggregate demand.
- International spillovers (Figure 13): transmitted mainly through trade linkages and are relatively small.

B. Temporary but persistent increase in borrowers’ riskiness
- Experiment: temporary but persistent increase in riskiness of U.S. corporate borrowers that raises the corporate financing premium by 1 percentage point on impact (Figure 14). The shift in risk perception is persistent but declines by roughly half every 2 years.
- On impact:
  - Real GDP declines by approximately ½ percent.
  - Inflation falls by less than ¼ percentage point.
- Mechanisms:
  - Increased perceived corporate risk raises borrowing costs, increasing cost of capital and reducing business investment.
  - Higher cost of capital reduces profitability, dividends, and household wealth; firms reduce production and labor demand, lowering wages and employment.
  - Consumption falls by much less than investment.
  - Weaker activity reduces inflation slightly; monetary authority decreases policy interest rate to stimulate demand and return inflation to target.
  - Resulting slight fall in short-term real interest rate yields a small real depreciation, slightly increasing exports and decreasing imports; current account improves modestly in the short run.
- Fiscal impact: minor through automatic stabilizers; fiscal deficit returns to balance quickly.

Box II: Impact of the BGG financial accelerator
- GIMF incorporates the financial accelerator adapted from Bernanke, Gertler, and Gilchrist (1999).
- Figure 15 illustrates the accelerator’s impact in a temporary decline in savings (increase in consumption) and a temporary 10-year increase in the productivity growth rate.
- In the model without a financial accelerator (dashed red line), a sudden increase in consumption increases output and inflation, which the U.S. monetary authority damps with a higher monetary policy rate, increasing cost of capital and putting downward pressure on investment.
- Incorporating the financial accelerator is motivated by the empirical positive correlation between investment and consumption in business cycles; the accelerator alters how consumption and investment co-move following shocks.

*Source: _wp1355 - Section 3*

### Section 4

### _wp1355 - Section 4

### Financial Accelerator and Firm Net Worth
- With the accelerator in place, higher output and thus profits combined with a small reduction in the real value of firms' debt due to the first period’s higher-than-expected inflation increases firm net worth, making them less risky to lenders.
- Effects on financing:
  - Firm external financing premium falls, helping to somewhat offset the increase in the cost of capital coming from the higher monetary policy rate.
- In the case of a sustained increase in productivity:
  - Increase in profitability is the primary factor increasing firms’ net worth.
  - The unexpected increase in inflation is quite small and plays only a marginal role.
  - Higher net worth drives down finance premia and stimulates higher investment relative to the no-financial-accelerator case.

### Box III — Impact of Leverage under an Increase in Borrower Riskiness
- Experiment: identical increase in corporate borrower riskiness for three steady-state leverage ratios (corporate debt relative to firms’ net worth):
  - 1
  - 1.75
  - 2.5
  - (A leverage ratio of 1 is the baseline calibration for all other shocks in this paper.)
- Mechanisms and outcomes:
  - Higher steady-state leverage raises the cutoff profitability rate entrepreneurs must achieve to avoid bankruptcy.
  - For a given increase in risk, higher steady-state leverage increases the probability of default.
  - The rise in external finance premia is larger when steady-state leverage is higher.
  - Higher leverage makes the user cost of capital more sensitive and business investment more volatile.
  - The real interest rate is slightly more volatile under higher steady-state leverage.

### V. Properties of Demand Shocks

#### A. Temporary Increase in Private Domestic Demand
- Shock specification:
  - One-year one percentage point increase in U.S. private consumption demand.
  - One-year four percentage point increase in private investment demand.
- U.S. domestic outcomes:
  - Short-run GDP increases by just over 1 percent.
  - Inflation rises by less than ¼ percentage point.
  - Higher investment accumulates into a higher stock of private capital, causing a persistent increase in output.
  - Firms increase labor demand; wages rise.
  - Higher wages combined with higher cost of capital raise production costs; firms pass marginal cost increases to output prices.
  - Monetary policy: in response to accelerating inflation, the monetary authority increases the policy interest rate to suppress demand and return inflation to target.
  - Higher policy rate flows to the real interest rate, pushing down investment demand by raising the cost of capital.
  - Households reduce consumption and temporarily increase saving due to higher real interest rate.
  - Fiscal policy: the fiscal authority reacts counter-cyclically by reducing general transfers to households, improving the fiscal balance.
  - External sector:
    - Real effective exchange rate appreciates through uncovered interest parity.
    - Appreciation decreases the price of U.S. imports and increases the price of U.S. exports.
    - Combined with direct spillovers into imports from higher demand, the trade balance is reduced, easing demand on domestic capacity.
- Rest of world:
  - Real GDP initially expands by roughly one-seventh the amount of the U.S. increase.
  - Increase in U.S. demand for exports raises foreign import demand.
  - Households abroad substitute away from imports toward domestically produced goods in response to higher import prices.
  - Small increase in inflation abroad prompts foreign monetary authorities to increase policy rates to dampen inflation pressures.

#### B. Permanent Increase in Saving
- Shock specification:
  - Permanent, one percentage point increase in the saving of OLG households in the United States.
- U.S. outcomes:
  - Short-run: mildly negative impact on activity; real GDP decreases in the first year by less than ¼ percent.
  - Long-run: permanently higher real GDP — text reports:
    - "in the long run, the permanently higher savings rate raises real GDP by almost ¼ percent."
    - Later description: "In response to the increase in income and the higher level of wealth, real GDP increases in the long run by almost ½ percent."
  - Inflation:
    - Declines initially and then takes several years to return to target as demand converges to the new higher supply level.
    - Firms decrease demand for labor; wages fall.
    - Rental rate of capital falls; lower marginal production costs lead firms to decrease output prices, with inflation falling by just under ¼ percentage point after several years.
  - Monetary and real interest rates:
    - Monetary authority reduces the policy interest rate to increase demand and return inflation to target.
    - Equilibrium interest rate falls as increased saving reduces the return; lower policy and equilibrium rates reduce the user cost of capital and increase investment demand.
  - Dynamics:
    - Lower real interest rates entice households to increase consumption and unwind part of increased saving.
    - Higher investment accumulates into a larger capital stock, yielding a permanently higher level of output and household income.
  - External sector:
    - Short-run: depreciation in the real effective exchange rate through uncovered interest parity; imports become more expensive and exports cheaper, improving the trade balance.
    - Increase in demand for foreign assets improves the net foreign asset position and results in a permanent improvement in the current account.
    - Long run: pressure for the real effective exchange rate to appreciate given the higher equilibrium level of foreign assets.
- Rest of world:
  - Reduction in demand for exports; foreign households substitute toward imports responding to lower import prices.
  - Initial reduction in foreign real GDP and a small initial decline in inflation.
  - Global saving increase leads to a lower global equilibrium real interest rate, reducing user cost of capital and permanently raising investment and productive capacity abroad, boosting foreign real GDP permanently in the long run.

### VI. Properties of Supply Shocks

#### A. Permanent Increase in the Level of Labor-Augmenting Productivity in Intermediate Goods Production, and the Balassa-Samuelsson Effect
- Shock specification:
  - One percent increase in the level of labor-augmenting productivity in both tradable and nontradable intermediate goods sectors, and isolating tradable intermediate goods sector where calibrated to yield the same GDP increase as the 1 percent economy-wide increase.
- Mechanisms and outcomes:
  - Higher productivity raises marginal products of capital and labor, increasing demand for these factors; firms offer higher real wages and real rental rates on capital.
  - Large increase in household income and private domestic demand.
  - Marginal production costs decline overall; firms decrease output prices and inflation falls slightly in the short run.
  - Monetary policy: monetary authority lowers the policy interest rate to increase demand and return inflation to target.
  - Lower policy rate reduces the user cost of capital and increases investment demand; households increase consumption and temporarily decrease private saving.
  - Fiscal policy: fiscal authority reduces general transfers to households, temporarily improving the fiscal balance.
  - Real effective exchange rate:
    - When productivity increases in all intermediate goods sectors, output prices fall but the relative price of U.S. tradable goods does not fall; real effective exchange rate depreciates to sell additional output abroad.
    - When productivity increases only in the tradable intermediate goods sector:
      - Tradable intermediate goods prices fall; nominal wages rise in the tradable sector, and because labor is mobile across sectors but not countries, nominal wages rise in the nontradable sector as well.
      - Absence of productivity improvement in the nontradable sector forces nontradable intermediate goods prices up, amplifying the decline in the relative price of tradable goods.
      - With elasticities of substitution above unity, this shift in relative prices leads to appreciation in the real effective exchange rate — the Balassa-Samuelson effect.
  - Long run: current account shifts to a small deficit and net foreign assets decline as domestic households do not supply all savings required to finance increased domestic capital stock.
- Rest of world:
  - U.S. productivity increases spill over to productivity in tradable and nontradable intermediate goods sectors abroad.
  - Global demand for investment outpaces saving, putting small upward pressure on the world real interest rate, slightly crowding out private demand abroad.
  - Rest of world experiences increases in real GDP with dynamics similar to the United States.

#### B. Temporary 10-Year Increase in the Growth Rate of Labor-Augmenting Productivity in All Intermediate Goods Production
- Shock specification and calibration:
  - Ten-year anticipated increase versus ten-year unanticipated increase in the growth rate of economy-wide labor-augmenting productivity in the United States.
  - Calibrated to increase the level of real GDP each year by just under ¼ percent, resulting in a permanent increase in the level of real GDP by roughly 2 percent at the end of ten years.
- Mechanisms and outcomes:
  - Productivity increase raises marginal products of capital and labor, increasing demand for these factors and household incomes; private domestic demand rises.
  - Two competing effects on output prices:
    - Downward pressure on marginal production costs reduces firms’ output prices.
    - If households anticipate permanent income growth, they increase current spending to smooth lifetime consumption, raising demand, production costs, and output prices.
  - Anticipated vs. unanticipated scenarios:
    - Unanticipated (households do not perceive future income growth): consumption does not increase as much; decrease in marginal cost dominates; short-run inflation falls slightly.
    - Anticipated (households perceive future income growth): households increase spending in the short run; demand effect dominates; inflation rises in the short run by less than ¼ percentage point.
  - Monetary and fiscal responses in the anticipated case:
    - Monetary authority raises the policy interest rate to return inflation to target; higher policy rate raises the real interest rate, reduces investment demand by increasing user cost of capital, and entices households to temporarily increase saving.
    - Fiscal authority reduces general transfers to households, improving the fiscal balance temporarily.
  - Exchange rate and external sector:
    - Anticipated increase: higher real interest rate and currency appreciation through uncovered interest parity; appreciation reduces import prices and raises export prices, reducing trade balance and current account, amplified by higher import spillovers.
    - Unanticipated increase: opposite short-run exchange rate, trade balance, and current account outcomes.
    - Long run: real effective exchange rate depreciates whether anticipated or not to increase competitiveness of U.S. exports and absorb the permanently higher U.S. output.
- Rest of world:
  - A fraction of the U.S. productivity increase spills over into foreign productivity, producing similar effects abroad.

#### C. Permanent Increase in Competition in the Labor Market that Decreases the Markup in Real Wages
- Shock specification:
  - Permanent increase in labor market competition that reduces the wage markup by five percentage points in the United States.
- Outcomes:
  - Short run: mild disinflationary pressure.
  - Long run: real GDP increases almost 1½ percent above baseline.
  - Mechanisms:
    - Lower wage markup reduces the wedge between the wage paid by producers and the wage demanded by households.
    - Firms respond to lower labor costs by permanently employing more labor and renting more capital.
    - Long-run increase in labor supply more than offsets lower wage rates, increasing labor income and human wealth.
    - Higher human wealth induces households to permanently save and consume more, aligning long-run demand and productive capacity and raising real GDP.
    - Lower marginal production cost allows firms to lower output prices, producing a mild decline in inflation.

*Source: _wp1355 - Section 4*

### Section 5

### _wp1355 - Section 5

### Short-run monetary and fiscal responses; exchange rate and saving dynamics
- The monetary authority decreases the policy interest rate to increase demand and return inflation to target.
- The fiscal authority reacts counter-cyclically to the pickup in real activity by reducing general transfers to households, temporarily improving the fiscal balance.
- In the short-run, the decrease in nominal interest rates generates a depreciation of the real effective exchange rate through the uncovered interest parity condition.
- The depreciation increases the price of imports and decreases the price of U.S. exports.
- In the long run, the reduction in the wage markup has an identical exchange rate impact as an economy-wide increase in productivity: the real effective exchange rate must depreciate so that the higher level of U.S. exports will be absorbed by the rest of the world.
- The permanently higher level of U.S. saving is larger than the increase in the desired capital stock, and consequently, the long-run real interest rate declines to equilibrate the supply and demand for savings.
- Dynamics described in Figure 26:
  - The rest of the world responds to lower import prices by substituting towards imports and away from domestically produced goods.
  - Real GDP initially declines slightly.
  - Eventually, the lower world real interest rate, resulting from higher saving in the United States, exerts upward pressure on the demand for investment goods through a lower user cost of capital.
  - Households increase consumption and decrease saving over time.
  - The initial fall in real GDP from a lower trade balance is offset after several years by the increase in domestic demand from a lower real interest rate, resulting in a permanently higher level of output.

### D. Permanent increase in competition that decreases intermediate goods price markups
- Simulation: permanent increase in competition reduces the markup over marginal cost in the U.S. tradable and nontradable goods sectors by five percentage points.
- Long-run real GDP outcomes:
  - Increase in real GDP is roughly 2 or 3 percent, depending on the sector in which the markup declines.
  - In the case of increased competition in the tradable goods sector, real GDP rises to 2 percent above baseline over ten years.
  - In the case of increased competition in the nontradable goods sector, real GDP rises to 3 percent above baseline over ten years.
- Inflation and prices:
  - Despite the decline in output price inflation in the sector experiencing increased competition, overall CPI inflation rises slightly owing to increased demand for both investment and consumption goods.
  - Along the adjustment path to the new equilibrium, overall demand in the economy exceeds supply temporarily, resulting in slightly higher CPI inflation, peaking in year 5 at approximately ¼ percentage point.
  - The lower rate of price inflation in the affected sector is evident in the decline in that sector’s relative price.
- Income, labor, and investment effects:
  - The decline in the markup results from higher competition, reflected in higher demand for both capital and labor.
  - Higher labor and investment income for households raises household consumption permanently.
  - The increased output initially drives down prices in the expanding sector, raising the implicit return to labor and inducing households to further boost labor supply.
  - The expansion in supply capacity is roughly matched with permanently higher demand for investment and consumption goods.
- Monetary and fiscal policy responses:
  - In response to the increase in inflation, the monetary authority raises the policy interest rate to moderate demand and return inflation to target.
  - The fiscal authority reacts counter-cyclically by reducing general transfers to households, temporarily improving the fiscal balance.
- Real interest rate dynamics:
  - In the short run, the immediate increase in demand for investment slightly outpaces the rise in saving, exerting persistent upward pressure on the real interest rate.
  - Higher real interest rates raise the user cost of capital and moderate investment demand, and entice households to temporarily reduce consumption and increase saving.
  - In the long run, the increase in household income raises saving by more than the demand for investment, producing a small reduction in the real interest rate.
- Real effective exchange rate implications:
  - Increased competition in the tradable goods sector: fall in the relative price of tradable intermediate goods creates pressure for the real effective exchange rate to appreciate in the long run.
  - Increased competition in the nontradable goods sector: reduction in the relative price of domestic nontradable intermediate goods creates pressure for the real effective exchange rate to depreciate in the long run.

### VII. Properties of international shocks — overview
- This section presents effects of two simulations related to the external sector of the United States:
  - A temporary increase in sovereign risk.
  - A permanent increase in U.S. tariffs.

### A. Temporary increase in sovereign risk (100 basis points)
- Shock: temporary but persistent 100 basis point increase in the risk premia associated with sovereign debt obligations and other dollar-denominated assets (investors require higher returns to hold U.S. assets).
- Macroeconomic and price-level impacts:
  - Real GDP falls by just over ¼ percent because of a fall in domestic demand in the short and medium run.
  - Inflation falls more modestly.
  - The dollar depreciates by almost 1½ percent.
- Investment, wealth, and labor:
  - Business investment declines due to the increase in the user cost of capital from higher real interest rates.
  - Increased costs reduce profitability and the stream of future dividends, lowering household wealth.
  - Higher costs induce firms to scale back production and labor demand slightly; wages post moderate declines.
  - Employment in the tradable goods sector is positive in the short run because of increased foreign demand from the currency depreciation; employment falls in the nontradable goods sector.
  - Lower wealth and slightly lower labor income lead households to reduce consumption.
- Monetary and financial conditions:
  - Weaker demand leads the U.S. monetary authority to lower the nominal policy interest rate to return inflation to target.
  - Market interest rates remain well above baseline since confidence in U.S. assets is low.
  - Loss of confidence in U.S. assets results in a depreciation of the real effective exchange rate; the decline in the foreign currency price of U.S. exports increases demand for U.S. goods.
  - Imports fall due to the fall in domestic demand and the depreciation; the current account improves in the short run.
- Fiscal effects:
  - The increase in the sovereign risk premium directly increases debt-servicing costs, driving up the fiscal deficit.
  - In the medium term, fiscal balance is restored by lowering general transfers to households.

### B. Permanent increase in tariffs (ten percentage points)
- Shock: permanent, ten percentage point increase in U.S. tariffs on imports from all other regions.
- Macroeconomic impacts:
  - There is a permanent decrease in the level of real GDP of around 1 percent.
  - Inflation increases marginally in the short run, but quickly returns to baseline.
- Distribution and trade volume effects:
  - Income from tariffs is distributed to households via general transfers, which increases private consumption.
  - Tariffs raise the domestic price of imports, reducing import volumes.
  - With the United States importing less, it need not export as much to maintain its desired level of net foreign assets, leading to a real appreciation that moderates foreign demand for U.S. goods.
- Investment and long-run effects:
  - Lower demand for final goods production in the United States means firms require less capital, and business investment declines in the long run.
- Current account and inflation dynamics:
  - Despite significant adjustment in the real effective exchange rate, imports, and exports, the net impact on the current account is small, with only a tiny permanent deterioration.
  - Initially, inflation rises due to the increase in import prices from the imposition of the tariff.
  - Lower production leads to a decline in demand for labor, a fall in wages, and a fall in marginal costs, eventually producing a small reduction in inflation.
  - Monetary policy tightens temporarily when the tariff is first imposed, but monetary policy is quickly relaxed and the short-term interest rate declines.
  - The net effect on fiscal policy is minor because the extra revenue from tariffs is redistributed to households via higher transfers.
- International repercussions:
  - A unilateral U.S. tariff increase reduces real GDP in the rest of the world by roughly the same amount as in the United States when adjusted for relative sizes of the regions.
  - Effects in the rest of the world are roughly ⅓ the size of those in the United States, and the rest of the world is roughly three times larger than the United States in terms of economic size.

*Source: _wp1355 - Section 5*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp1355.pdf_