„BMW-Model“: A new framework for teaching macroeconomics : Monetary and Fiscal Policy Interaction in a closed Economy

Peter Bofinger,Eric Mayer

Universität Würzburg

IntroductionBMW Model

The BMW-Model: New Keynesian Macroeconomics for Undergraduates

Part 1: "The BMW model: a new framework for teaching monetary macroeconomics in closed and open economies", Würzburg Economic Paper No. 34, July 2002.

Part 2a: "The BMW model: A new framework for teaching macroeconomics: Monetary and fiscal policy

interaction in a closed economy", mimeo, October 2003 . Part 2b: "Monetary and fiscal policy interaction in the euro

area with different assumptions on the Phillips curve", Würzburg Economic Papers No. 40, October 2003 .

Part 3: "The BMW model as a static approximation of a foreward-looking New Keynesian macromodel", "Würzburg Economic Papers No. 42, November

The BMW-Model

Closed economy

Application I

Application II

Application III

• Nominal Interest Rate Trap

• Investment Trap

• Ordinary Times • Stabilization Bias (Ambitious Government)

Building Blocks“Static New Keynesian Macro Model “

Static Phillips curve

Static IS-Equation

Policy rules

0 2dy

1y a br g

2 20ECBL y

2 2 GL y g

Monetary policy

Fiscal policy

Chart 1: What does fiscal policy do?

r

y

r0

1d1y r,g

0d0y r,g

2d2y r,g

0y1 y2

r(1,2)1y a br g

Strategic Interaction: Monetary Policy

Monetary Policy

Which results in the following instrument rule („reaction function“)

2 20CBL y

s.t.

0 2dy 1y a br g

1 22

1opt a dr

b b b dg

b

Chart 3b: The Instrument Rule („Reaction function“): What is the optimal interest rate r* if the government chooses g

r

g

a

b

b

r*(g)

0 g1

r1

Strategic Interaction: Fiscal Policy Fiscal policy:

Which results into the following instrument rule („reaction function“)

2 2GL y g

1y a br g s.t.

2 12 2

a bg r

r

g

a

b

2

b

g *(r)

Chart 4b: The Instrument Rule („Reaction function“): What is the optimal fiscal stance g* if monetary policy r

Application I

A Nominal Interest Rate Trap

Investment Trap

Chart 5: Assume that the economy is hit by a large demand shock: Nominal interest rate trap

r

yr1

0d1y r 0,g

r0

d0y r,g

r1(g0,1)

r1(g*,1)

1d2y r 0,g

A B

r

y

r0

1d1y r,g 0

d0y r,g

0y1

r(1,2)

r1 r(1,2)

Chart 6: Assume that investors are admost pessimistic: Investment Trap

Application II Ordinary Times

r*(g)r

g

b

r

g

2

b

g*(r)

Nash-Equilibrium (r*,g*)

0

Chart 8b: Nash Equilibrium:

Outcome of the game

r

y

r0=(a/b)

d0 0y r,g 0

0

Application III Stabilization bias: Debt Bias

Fiscal Policy is overly ambitious and tries to push output above potential

2 2G kL y g

r

g

a

b

2

b

g *(r)

biasg *(r)

a k

b

Chart 10a: The New Reaction Function: For every real interest rate r, fiscal policy is more expansive

r

y

r0

bd1 iasgy r,

0d0y r,g

0 y1

r(1,2)

Chart 10b: Which looks in the (y,r)-space as follows

r

y

r0

d0y r,g 0

d2y r,g 0

0

r1

B

C

y>0

A

Chart 11a: But as monetary policy can push ist preferred outcome through

r

g

a

b

g *(r)biasg *(r)

a k

b

r*(g)

Nash-Equilibrium (r*,g*)

2

kg

1

*

2

2

a kr*

b b 1