Public Infrastructures, Public Consumption, and Welfare in a New-Open-Economy-Macro Model

IMF Working Papers, March 1, 2007

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Focus: trade-off in government allocation of public expenditures between productivity-enhancing public infrastructures and utility-enhancing public consumption.
Modeling approach: augments a standard New Open Economy Macroeconomics (NOEM) model by introducing productive public infrastructures.
Core result overview:
- A temporary increase in the domestic stock of public capital financed by a reduction in public consumption reduces domestic welfare in the short run because the temporary gains from higher productivity do not compensate domestic residents for the utility loss due to lower public consumption.
- If the policy shift is permanent, domestic utility is likely to increase, while foreign residents suffer short-run welfare losses but benefit from welfare gains in the long run.
- Implication: a permanent domestic reallocation of public spending might result in a virtuous global technological cycle.

Framework: modified NOEM model incorporating productive public infrastructures.
Policy experiment: reallocation of public expenditures toward public capital and away from public consumption.
Transmission channels highlighted:
- Productivity channel via higher domestic stock of public capital.
- Utility channel via lower public consumption affecting household utility directly.
- International spillovers producing asymmetric short-run and long-run welfare effects across domestic and foreign residents.

Temporary reallocation (increase in public capital financed by reduction in public consumption):
- Reduces domestic welfare in the short run.
- Temporary productivity gains do not offset the utility loss from reduced public consumption for domestic residents.
Permanent reallocation:
- Domestic utility is likely to increase.
- Foreign residents:
- Suffer short-run welfare losses.
- Benefit from welfare gains in the long run.
Global implication:
- A permanent domestic reallocation toward public infrastructure can initiate a virtuous global technological cycle.

Short-run vs long-run trade-off:
- Policymakers should weigh short-run utility losses against potential long-run welfare gains when reallocating public spending toward productive infrastructure.
International considerations:
- Domestic decisions on the composition of public spending have cross-border welfare implications—short-run costs for foreign residents but potential long-run gains globally.
Design of fiscal adjustments:
- Temporary reallocations may be politically costly domestically because of immediate utility losses; permanence of policy shifts changes welfare calculus favorably for the domestic population.

Giovanni Ganelli and Juha Tervala, March 1, 2007 — IMF Working Paper