„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