Published: 26.01.2023 Updated: 27.12.2023

Patrick Grüning, Andrejs Zlobins

Working paper 9/2023

Given the decades-high inflation, central banks are complementing conventional rate hikes with quantitative tightening (QT), i.e. a reduction of the sizeable asset hold- ings accumulated during the quantitative easing (QE) era. In this study, we employ empirical (proxy-SVAR) and structural (medium-scale NK DSGE) frameworks to study the macroeconomic implications of QT. Our empirical findings show that the impact of QT has been relatively muted in the US, suggesting asymmetric effects of QT compared to QE. This finding is corroborated by model simulations, calibrated to the post-pandemic high inflation environment. Nevertheless, QT can partly sub- stitute conventional rate hikes by creating some deflationary pressure and requiring less aggressive conventional policy action. QT produces smaller effects in the euro area (EA) due to the smaller share of private bonds on the ECB’s balance sheet. However, a potential concern for QT in the EA is the proliferation of fragmentation risk. We empirically argue that the deployment of market-stabilisation QE can be used to stabilise sovereign spreads without creating considerable inflationary pres- sure in case QT leads to disorderly market dynamics.

Keywords: monetary policy, quantitative tightening, quantitative easing, proxy- SVAR, DSGE

JEL codes: C54, E31, E52, E58, G12

António Afonso, Josée Alves, Oļegs Matvejevs, Oļegs Tkačevs

Working paper 8/2023

We examine the relationship between inflation and fiscal sustainability with a two-step approach.In the first step, we estimate to estimate a country-specific time-varying measure of fiscal sustainability using the fiscal reaction function. This function captures the response of the primary balance to changes in the public debt ratio. In the second step, we examine how various measures of inflation such as headline inflation, core inflation, energy inflation, and food inflation affect the estimate of fiscal sustainability found previously. Our findings indicate that higher inflation rates contribute positively to the measure of fiscal sustainability, specifically through core inflation causing an improvement in fiscal sustainability, while the effect of energy inflation is conversely found to be negligible or even negative. These results imply that the initial burst of inflation caused by the energy price shock in 2021 probably did not help improve fiscal sustainability, whereas the subsequent high core inflation had a positive effect.

JEL codes: C23, E31, E62, H50, H62.

Keywords: fiscal sustainability; fiscal reaction function; time-varying coefficients; euro area; inflation; core inflation; panel data

Konstantīns Beņkovskis, Dzintars Jaunzems, Oļegs Matvejevs

Working paper 7/2023

We propose a novel method for modelling energy substitution in CGE models using energy processes defined according to the purposes of energy use. The purpose-based approach is superior for modelling the green transition because it closely mimics firms’ decisions regarding switching energy sources and is more parsimonious, relying on fewer industry-specific elasticities in the production structure. Latvia’s Computable General Equilibrium (CGE) model is an integral part of the joint CGE-EUROMOD modelling system used for policy simulations at Latvijas Banka. We improve this model by
1) incorporating endogenous substitution of energy resources by enterprises through the proposed purpose-based approach,
2) including the accounting of greenhouse gas (GHG) emissions generated by all public and private sector entities, and
3) introducing explicit modelling of expenses related to these emissions both due to state-level levies and participation in the EU Emissions Trading Scheme (EU ETS).

To illustrate the advantages of the augmented model, we simulate a scenario in which Latvia follows a linear path to achieve GHG emissions reduction consistent with its European Green Deal objectives by 2030 achieved solely through carbon pricing. The analysis of this scenario suggests that over a three-year horizon ending in 2025, the resulting cumulative welfare losses would exceed 2% in the case of an uncompensated carbon tax (resulting in a budget balance improvement of 2.6% of GDP) or amount to 0.3% if government consumption is increased to keep the budget balance constant. If instead the size of the public sector is maintained and the higher carbon tax is compensated by a VAT rate cut, economic activity expands by 1% but GHG emissions fall by 40% less.

Keywords: CGE model, Latvia, GHG emissions, Emissions Trading Scheme, carbon tax, energy substitution, green transformation, energy transition, European Green Deal, EUROMOD

JEL codes: C68, Q58, Q48, Q54, Q41

Patrick Grüning, Zeynep Kantur

Working paper 6/2023

The most effective approach to tackling climate change is by decarbonising produc- tion processes. However, decarbonisation might render assets stranded, impacting not only the relevant sector but also causing a ripple effect across all sectors, thereby potentially destabilising macroeconomic stability. We develop a multi-sector New Keynesian model with two physical capital types (brown and green) and input- output linkages to examine the economic impact of sector-specific capital stranding. Stranded brown capital in the brown sector yields a relocation of economic ac- tivities to the green sector and thus environmental benefits with small aggregate consequences, while brown capital stranding in both sectors implies larger economic costs and smaller environmental benefits. Brown consumption taxes and green pro- ductivity shocks facilitate the green transition, while brown investment taxes or green investment subsidies turn out to be less favourable policies in this respect. However, a combination of these two investment policies yields favourable economic and environmental outcomes. Doubling the carbon tax in the brown sector yields significant relocation activities at relatively small economic costs. If the central bank responds strongly to short-run inflationary pressures of carbon tax increases, this leads to larger output losses in the short run and higher output gains in the long run.

Keywords: capital utilization, stranded assets, production network, climate change, fiscal policy, monetary policy

JEL codes: E22, E32, E52, E61, L14

Andrejs Zlobins

Working paper 5/2023

Portfolio rebalancing is a key mechanism through which central bank asset purchases flatten the yield curve, thus providing additional monetary policy accommodation when conventional policy rate setting is constrained by the effective lower bound. Existing literature provides ample evidence that this channel has played a major role in compressing the long-term interest rates and provided a broad-based easing of financial conditions for firms and households in the euro area. However, this evidence originates from either aggregate euro area or its largest jurisdic- tions, leaving the effects of the Eurosystem’s asset purchases on smaller member states, such as Latvia, unclear. Therefore, we employ a bilateral structural vector autoregression, featuring both aggregate euro area and Latvian blocks, as well as a panel structural vector autoregression with cross-sectional heterogeneity to obtain evidence from both macro-level and bank-level data in order to shed some light on the transmission of QE to the Latvian economy. Our findings suggest that QE led to a compression of sovereign borrowing costs in Latvia and boosted economic ac- tivity and prices. At the same time, we also document that the further pass-through to domestic financial conditions was weak owing to limited asset rebalancing by the domestic banking sector in response to the Eurosystem’s QE. Instead, we show that Latvian yields were compressed due to direct intervention of the central bank in the bond markets and portfolio readjustment of foreign investors. Our study thus provides additional evidence that the transmission of common monetary policy to the Latvian economy is impaired via the domestic banking sector.

Keywords: quantitative easing, portfolio rebalancing, monetary policy, euro area, Latvia

 JEL Codes: C54, E50, E52, E58

Karsten Staehr, Oļegs Tkačevs, Katri Urke

Working paper

This paper estimates fiscal reaction functions to examine the importance of inflation and inflation sur- prises for fiscal outcomes in the euro area countries, covering the first 12 countries to join the euro area. The effect of HICP inflation on the primary fiscal balance in per cent of GDP is positive, and statistically and economically significant. The positive effect stems from both the revenue side, particularly direct taxes and indirect taxes, and the expenditure side, particularly primary current expenditures. The effects of HICP inflation on the primary balance and other fiscal outcomes appear in large part to stem from inflation surprises, which are errors in the inflation forecasts available for preparing budgets. The positive effect on the primary fiscal balance does not exhibit noticeable non-linearities.

Keywords: Public finances; Fiscal outcome; Inflation; Inflation surprises

JEL Codes: H6, H62, H68, E31

Konstantīns Beņkovskis, Oļegs Tkačevs and Kārlis Vilerts

Working paper

This paper studies the employment effect of the job retention scheme implemented during the Covid-19 pandemic. Using firm-level data from Latvia, we investigate whether a change in the number of employees in firms that received support from the job retention programme has been different from that of similar firms which did not receive such support, and whether these differ- ences have disappeared over time. We find strong evidence that job retention scheme participants in Latvia were less likely to cut employment and that this effect persisted for several months after receiving support. Participation in the job retention scheme affected both the likelihood of a firm’s survival and the rate at which employees were laid off. Our results also suggest that the participation effect was not uniform across firms, with the effect being less pronounced in service sectors with a higher level of contact intensity and more pronounced in sectors with a higher proportion of highly skilled employees.

Keywords: Job retention schemes, idle-time allowance, Covid-19, employment

JEL Codes: E24, H12, J62, J68

Konstantīns Beņkovskis, Oļegs Matvejevs

Working paper

This paper describes the new version of Latvian CGE model, which is now an integral part of the joint CGE-EUROMOD modelling system. Special attention is devoted to the labour market and consumption blocks of CGE that are substantially improved compared with the previous version. We briefly describe the motivation to link Latvian CGE with Latvian EUROMOD and provide major technical details. We also provide an example of the policy simulation by the joint CGE-EUROMOD system, demonstrating how the introduction of the progressive personal income tax rate affected the Latvian economy at macro, industry and micro level.

Keywords: CGE model, Latvia, labour market, consumption, EUROMOD

JEL codes: D58, C68, H2, H6, D9

Konstantins Beņkovskis, Ludmila Fadejeva, Anna Pluta, Anna Zasova

Working paper

In this paper, we link a CGE model with the tax-benefit microsimulation model EUROMOD for Latvia. The model linkage is done using an iterative top-down bottom-up approach, ensuring the convergence of changes in disposable income, employment and wage in both models. We also incorporate the unreported wage payments in CGE and EUROMOD to account for the substantial labour tax non-compliance in Latvia and improve the modelling of the fiscal sector.

Several simulations demonstrate the advantages of the joint CGE-EUROMOD system over the individual macro and microsimulation models. The lack of income distribution aspect and the scarcity of fiscal instruments in CGE can be overcome by the features of EUROMOD. The CGE model, on the other hand, provides macroeconomic spillovers that are missing in the simulations of EUROMOD.

Keywords: EUROMOD, CGE model, model linkage, informal sector

JEL codes: C68, D58, D90, J46