Spain in the Euro: a General Equilibrium Analysis

This paper analyzes the determinants of Spains macroeconomic uctuations since the inception of the euro in 1999, with a special attention to observed growth and ination di¤erentials with respect to the rest of the European Monetary Union (EMU). For that purpose we estimate the Banco de España DSGE model of the Spanish economy and the rest of the Eurosystem (BEMOD). We nd that observed di¤erentials are the result of a combination of asymmetric country-specic shocks (in particular, demand and productivity shocks for growth and cost-push shocks for ination) as well as asymmetric economic structure (especially lower nominal wage and price rigidities in Spain). Finally, we nd that EMU membership has had a non-negligible e¤ect on observed di¤erentials. JEL codes: C11, C51, E17


Introduction
The aim of this paper is to study the determinants of Spain's macroeconomic ‡uctuations since the inception of the euro in 1999. Despite the common monetary policy, economic We would like to thank Angel Estrada, Juan Francisco Jimeno, Nooman Rebei and Alberto Urtasun for their help and very useful suggestions, and to Jesús Vázquez and participants of the conference "Estimation and Empirical Validation of Structural Dynamic Stochastic Models for the Spanish Economy" celebrated at Banco de España on March 13, 2009. Javier Andrés acknowledges …nancial support by CICYT grant ECO2008-04669. This paper represents the views of the authors and should not be reported as representing the views of the Banco de España or the Eurosystem. above that of the EMU as a whole, while annual GDP growth has averaged 0.96p.p. more in Spain than in the EMU (see Figure 1)  jan-99 jan-00 jan-01 jan-02 jan-03 jan-04 jan-05 jan-06 jan-07 jan-08 jan-09 Average inflation differential since start of EMU This paper revisits the model and estimates, using standard Bayesian procedures, the main parameters driving its dynamics as well as a wide variety of shocks that have hit the Spanish economy and the rest of the Eurosystem in the last decade. In this paper, the model has been augmented with respect to its original structure in several ways, such as adjustment costs in investment (rather than in capital) and foreign trade, Calvo-type employment smoothing functions (as in Smets and Wouters, 2003) and an EMU-wide exogenous di¤erence-stationary technology process among others. We …nd that our aggregate data set (consisting of 17 series) is particularly informative with respect to the Calvo parameters (which control the degree of nominal price and wage rigidities) as well as the standard deviation of shocks. Nominal wages and prices are estimated to be somewhat more ‡exible in Spain. Our data set is however not very informative regarding the degree of wage indexation to CPI in ‡ation, and so the estimate of this parameter basically re ‡ects 1 The Bank of Canada, the Riksbank, the Norges Bank, the Bank of Finland or the European Central Bank were among the …rst ones but now the amount of central banks who have a DSGE model for the analysis of their own economy has remarkably increased. our prior information that it is much higher in Spain than in the rest of the Eurosystem.

GDP growth differential Spain-EMU
Once the model is estimated, we infer the series of historical shocks that have generated the observed series. It is then possible to analyze the determinants of Spain's cyclical performance in the euro regime. Our main variables of interest are the observed di¤erentials of GDP growth and CPI in ‡ation with respect to the rest of EMU. In order to explain these di¤erentials, we focus on two aspects. On the one hand, asymmetries in country-speci…c shocks lead to asymmetric growth and in ‡ation ‡uctuations. On the other hand, even in response to common shocks, asymmetries in economic structure (as represented by the structural parameters) also imply ‡uctuations in growth and in ‡ation di¤erentials.
Our …ndings can be summarized as follows. First, our historical decomposition of the observed di¤erentials by types of shocks indicate that such di¤erentials are largely the result of asymmetric country-speci…c shocks. We …nd a particularly relevant role for demand and productivity shocks in the case of growth di¤erentials, whereas cost-push shocks are the major force behind in ‡ation di¤erentials. This result is further con…rmed by a counterfactual simulation in which we generate di¤erentials under the assumption that the shocks speci…c to Spain are the same as those speci…c to the rest of EMU; our simulation shows that such counter-factual di¤erentials would have behaved rather di¤erently from the actual ones. Interestingly, common shocks (such as oil shocks) are also an important driving force of in ‡ation di¤erentials, suggesting that the di¤erences in economic structure between both regions have a relevant role in shaping such di¤erentials. 2 In order to investigate this possibility, we simulate again counter-factual di¤erentials under the assumption that the structural parameters of the Spanish economy are the same as those estimated for the rest of EMU. We …nd that, while growth di¤erentials would have been fairly similar to actual ones, in ‡ation di¤erentials would have been less volatile for most of the sample period. With this regard, we …nd a especially important role for the lower degree of nominal rigidities estimated for Spain: the fact that common shocks are transmitted faster to the prices of Spanish products (which account for the larger weight of the Spanish consumption basket) implies that such shocks have stronger e¤ects on Spanish CPI in ‡ation and therefore a¤ect in ‡ation di¤erentials.
While Spain and the rest of the Eurosystem are hit by di¤erent shocks and also respond di¤erently to common shocks due to structural asymmetries, both regions share a common monetary policy. As a corollary to our main results, we also analyze how Spain's membership of the EMU has shaped observed di¤erentials. In order to investigate this issue, we set up a version of BEMOD in which both estimated parameters and historical shocks are the same as in the baseline model, but Spain retains an independent monetary policy for the peseta. We …nd that growth-in ‡ation trade-o¤s would have been di¤erent at certain points in time in this counter-factual scenario. For instance, in the 2002-2007 period of high in ‡ation and growth in Spain, we …nd that an independent Spanish monetary authority would have hypothetically implemented lower in ‡ation and slightly lower economic growth. While interesting, these results should not be viewed as having any normative or policy implications, because the structure of the model is not designed to capture some of the most important bene…ts of EMU membership.
The rest of the paper is organized as follows: the next Section describes the main characteristics of the model. Section 3 reports the Bayesian estimation and assesses its properties. Section 4 illustrates the main transmission mechanisms of the estimated model, which exploit its multi-country and multi-sector structure. Section 5 investigates the sources of in ‡ation and growth di¤erentials between Spain and the rest of the Eurosystem, with a special emphasis on the role of country-speci…c shocks and asymmetries in the structural parameters. It also analyzes the implications of EMU membership on Spanish di¤erentials.
Finally, section 6 presents some concluding remarks.

The model
There are three countries in BEMOD: Spain (H), the rest of the Euro Area (F ) and the rest of the world (W ). The latter block is exogenous and consists of AR(1) processes for demand, dollar goods prices, nominal interest rates and dollar oil prices. In each of the Eurosystem economies there are four types of agents: households, …rms, the domestic …scal authority and a monetary authority common to H and F . The representative household earns wages and rental rates of physical capital and uses his income to purchase a consumption basket, invest in productive capital and in durable goods, and buy nominal bonds (both euroand dollar-denominated). Firms operate in three sectors: tradables, non-tradables and durables, which are produced with di¤erent technologies across sectors using labor, capital and oil. Domestic …scal authorities collect (distortionary) taxes, consume a fraction of each country's output and issue nominal government bonds. Finally, the common monetary authority sets short-run nominal interest rates according to a Taylor rule.
The structure of production in each of the Eurosystem economies is represented by    There is a total of 21 possible sources of ‡uctuations in BEMOD. Four of them occur outside the Euro area, these are shocks to the oil price and to the rest of the world nominal interest rate, prices and demand. Three are shocks common to the whole Euro Area: to the common trend-stationary growth rate, to TFP and to the Eurosystem nominal interest rate. Finally, there are six country-speci…c shocks to Spain and the rest of Euro Area: to sector TFP in the tradables and non-tradables sectors, to investment, to preferences, to government expenditure and to price and wage mark-ups.

Households'preferences
Households maximize their welfare de…ned on consumption (c t ), the stock of durables (D t ) and leisure (1 n t ) subject to the following budget constraint is the rate of time preference, " a t a is preference shock, 1 and 1 D are the intertemporal elasticity of substitution of consumption and durables services respectively. ' represents the (inverse of) the elasticity of labour holding the marginal utility of consumption constant, captures the e¤ect of habits in consumption. All households are Ricardian and there is no explicit role for money in the model.
Households own durables and capital, which is supplied to producing …rms at the rental cost r t , and hold their wealth in a menu of assets including domestic bonds (B) and international (dollar-denominated) assets (A). s t is the nominal exchange rate. There are portfolio adjustment costs, (:), which are increasing in the ratio of net foreign asset position over value-added, a t A t =(va t P v t ), and which guarantees stationarity of this ratio. 3 Final consumption goods are produced by competitive …rms with a technology represented by the following CES aggregator, 3 See e.g. Schmitt-Grohe and Uribe (2001).
where is the elasticity of substitution between traded (c T t ) and non-traded goods (c N t ). The associated price index is given by, where P C N represents the consumption price of the non-traded good and P C T the corresponding price for the traded goods. The relative demand of non-traded versus traded goods only depends on its relative prices A similar CES technology holds for traded consumption c T t as a composite good home produced consumption goods, c H;t , goods imported from the Euro area, c F;t , and goods imported from the rest of the world, c W;t as well as oil, c Oil t : A similar structure is de…ned for c N t , I t , I P t , I T t and their associated price indices. We also assume, as Erceg, Henderson and Levin (2000), that each household supplies a di¤erentiated type of labour and thus enjoys some degree of monopoly power. Furthermore, households are price-setters in the labour market but only a fraction 1-W of workers reset their nominal wage each period. This generates the following log-linear wage in ‡ation where W is the degree of indexation and " w t is an economy wide wage-push shock.

Firms'technology and price setting
The production technology of each j 2 [0; 1] …rm in sector S = fN; T; Dg is represented by where O S t;j , is the oil input in production 4 , cu S t;j is capital utilization and z EA t , z t and z S t represent an Euro-Area-wide technology shock, a country-wide technology shock and a sector-speci…c technology shock, respectively.
Likewise we assume Calvo pricing with di¤erent probability of changing prices in each sector/country (1 S ). This yields the following sector speci…c de ‡ator in ‡ation equation, where S represents the degree of indexation and " p t is an economy wide cost-push shock.

Monetary policy and …scal policies
The model is closed with the policy rules: one …scal rule for each country and a common monetary rule. The government budget constraint is de…ned as: Fiscal policy is designed to prevent the level of debt from exploding. All w , k and c are assumed constant and we shall assume that lump-sum taxes (T t ) respond su¢ ciently to deviations of the level of debt as a proportion of GDP (b t ) from target b, Monetary policy is modeled as a Taylor rule as (in log-linear form), where b CP I t and c F CP I t are the home and EMU CPI in ‡ation rates, and …rst di¤erences in value added represent the output gap. R captures the degree of interest rate smoothing and and y the elasticity of response to deviations of in ‡ation and output from target.
The weights attached to domestic and foreign variables in the rule correspond to the relative size of the two economies; Spain represents roughly 10% of EMU GDP. " R t represents the unanticipated component of monetary policy.

Model parameterization and assessment
The parameterization strategy consists of keeping some parameters …xed and estimating those related to model dynamics using Bayesian techniques. The estimated parameters make a total of 60, which include those governing (i) the dynamics of sector output prices and wages, including both Calvo and indexation coe¢ cients, (ii) adjustment dynamics of investment and employment, (iii) the Taylor rule coe¢ cients describing the systematic behavior of the common monetary policy, and (iv) the stochastic processes driving all 21 model shocks, including their …rst order autocorrelations and standard deviations. The parameters we choose to keep …xed at their calibrated values correspond to the steady state ratios (share of non-tradables in consumption, etc., calibrated to match long-run averages in the data), the preferences (including the discount factor, inter-and intratemporal elasticities of substitution, labor supply elasticity, habits) 5 and the technology of production (factor shares and capital depreciation and utilization, calibrated to match input-output tables and long-run shares in the data). 5 We choose the intertemporal elasticity of consumption goods and of durables = 1 since we need log-utility in both to guarantee balanced growth, while we calibrate the habits in consumption because the estimated value tends to become almost 1, which was inconsistent with balanced growth.
The following table summarizes the main calibrated parameters. The rest of the calibrated values can be found in Andrés et al.(2006).  For the rest of the world: nominal 3-month interest rate in the US.
The set of observed variables seems to capture reasonably well the main features of the wage and price setting mechanism (see Guerrón-Quintana, 2008). We have explored some other combinations of series but they did not provide better estimation properties.
In particular we have tried several augmented data sets. One including imports series was not particularly successful and did not improve the estimation. The same occurs when the data set is augmented with sectoral in ‡ation and output data; in this case the estimated values for the price setting mechanism seem very much at odds with micro and macro evidence.
All the appropriate series in our sample are transformed into per-capita terms for conformity with model variables. We take quarterly growth rates of non-stationary series (consumption, investment, value-added, sectoral employments, real wages and exports) and demean each resulting series, whereas stationary series (in ‡ation and interest rates) are simply demeaned. The estimation period used is 1997Q1-2007Q4 which covers the EMU but also two years prior to the start of the common monetary policy, since in practice the Spanish monetary policy and exchange rate was already closely linked to that of its future EMU partners.
The prior distributions we have assumed follow standard practice in Bayesian estimation of similar DSGE models. In particular, we assume Inverse Gamma prior distributions for non-negative parameters (like the standard deviations of the shock processes), Beta prior distributions for parameters between 0 and 1 (like the shocks autocorrelations, the Calvo and indexation parameters and the coe¢ cient on interest rate smoothing in the Taylor rule), and prior Normal distributions for the Taylor rule coe¢ cients on the reaction to deviations of in ‡ation and valued added growth from target or for investment adjustment costs. Tables 2 and 3 show the posterior modes of the main parameters of interest, together with their prior mean. 6 Let us discuss …rst the prior means. Regarding the Calvo price parameters, their priors are based on studies that employ individual price data to compute frequencies of price adjustment [Álvarez and Hernando (2006) and Dhyne et al. (2006)].
Speci…cally, we consider that price stickiness in the tradable sector in Spain is similar to that in the euro area and consider a mean duration of 4 quarters, which implies T = 0:75.
For non-tradables, the evidence points to higher durations. We consider durations of 5 quarters for the euro area and 6 quarters for Spain, to allow for higher price stickiness in  for each Calvo ("theta") parameter departs noticeably from its assumed prior distribution, in grey (the green vertical line indicates the posterior mode value). In the case of the indexation parameters, "psi", the information content of the aggregate data is less clear.   Third, shocks to world demand are also found to be very big. The next more volatile are shocks to the price setting mechanism, cost-push shocks, in Spain but not in the rest of EMU, followed by oil price shocks. Comparing the shape of the priors and posteriors we …nd that the data is also very informative for the estimation of the shocks processes. We have checked the robustness of the parameter estimates by re-estimating the model excluding one of the 17 series in the data set at a time. 9 With very few exceptions the posterior mode of each parameter lies really close to the full data set case and most of the modes lie within the posterior distribution of the full data set estimation.

Assessing the model …t
Before investigating what the model implications are for understanding the similarities and divergences between the Spanish economy and the rest of the Eurosystem we need to assess the model's overall goodness of …t. One …rst test is to compare the evolution of the series used in the estimation process to that predicted by the model for the same variables.   tially more volatility in the observed variables than in the data, with the by-product that autocovariances and cross-covariances at di¤erent leads and lags also tend to be o¤ target.
This result contrasts with the reasonably good …t of the observed historical paths in Figure   6. We attribute this discrepancy to the short sample period used in the estimation (44 observations), which makes the comparison between the theoretical model moments (based on the assumption of iid shocks) and the sample moments problematic. 10   The forecast error variance of the value added growth di¤erential between Spain and the Eurozone is, then, mainly due to both areas speci…c demand and supply shocks, although demand shocks play a higher role. Idiosyncratic shocks to the Spanish economy seem to have a somewhat higher weight. Common and rest of the world shocks a¤ect but to a much lesser extent. The CPI in ‡ation di¤erential, in turn, depends mostly on the speci…c shocks that drive Spanish in ‡ation (cost push and wage push shocks).

Model properties
As expected, the main contributor to private consumption forecast error variance in both economies is the domestic demand shock, and to an even larger extent in the case of Spain. Private productive investment ‡uctuations are, on the contrary, mainly driven by domestic productivity shocks, while cost-push shocks and common real and monetary shocks play a signi…cant but much lower role. The role of the common shocks is found smaller in Spain than in the rest of the EMU. Finally, it is worth noting that the forecast error variance of nominal interest rates is explained to a higher extent by the variables to which the Eurozone common monetary authority reacts through its Taylor rule -thus the importance of the shocks that drive the variance of Eurozone in ‡ation and output: oil price and world interest rates, plus European and world demand-than to intrinsic interest rate shocks.

Figure 8. Variance decompositions in the estimated model
With respect to the impulse response functions, we will present only the e¤ects of an interest rate shock, and those of a productivity shock in the Spanish tradable goods sector.
They illustrate well the multi-country and multi-sector features of the model within a monetary union. Figure 9 displays the economy's reaction to a 1% shock to the nominal common interest rate. The increase in nominal interest rate depresses private consumption and investment both in Spain and the rest of EMU. Since EMU is Spain's main trading partner, total Spanish exports fall accordingly. As a result, production in the tradables sector drops more sharply than in the non-tradables sector. The fall in production and the stickiness of nominal wages (not shown in the …gure) produce a substantial fall in Spanish employment, with a maximum drop of about 2:5%.

The sources of growth and in ‡ation di¤erentials
Now we turn to analyzing the sources of the observed growth and in ‡ation di¤erentials between the Spanish economy and the rest of the Eurosystem. Here we focus on three potential explanations: di¤erences in economic structure (as represented by the structural parameters that are being estimated), asymmetries in the country-speci…c historical shocks, and Spain's membership of the Euro Area.
Once the model is estimated, it is possible to combine the observed series and the statespace representation of the estimated model so as to infer the series of historical shocks that would have produced exactly the observed series. 11 By simulating the path of the endogenous variables conditional on each series of historical shocks, we can then calculate the contribution of each particular type of shock to the observed series. 1 1 The estimated historical shocks are available upon request from the authors. Figure 11 displays the contribution of di¤erent groups of shocks to observed year-on-year GDP growth in Spain and the rest of EMU, as well as to the resulting growth di¤erential. 12 The solid lines represents the observed series, in annual averages of quarterly observations.
It is important to note that, since all our observable series have been demeaned prior to estimation, the structural shocks of the model explain only the deviations of each variable with respect to its sample average. Hence, the contributions of the diverse type of shocks add up to the observed di¤erential series minus its sample average. shocks as well as bene…cial EMU-speci…c productivity and demand shocks. Note …nally that, although shocks from the rest of the World have had an important e¤ect on each region's GDP growth at certain historical dates, the fact that their e¤ects are fairly symmetric implies that they have not made an important contribution to growth di¤erentials.  which is the set of di¤erentials that would have been observed if the shocks speci…c to the Spanish economy had been exactly the same as the shocks speci…c to the rest of EMU. 13 By comparing these counter-factual di¤erentials to the actual di¤erentials (y dif f ), we can isolate how the latter have been a¤ected by the occurrence of country-speci…c shocks.    which is the set of di¤erentials that would have been observed in the counter-factual scenario with independent monetary policy in Spain, given the parameters and historical shocks estimated in the baseline model. In particular, we assume that the coe¢ cients in Spain's monetary policy rule would have been the same as those estimated for the ECB in Table 2, with the di¤erence that the peseta interest rate responds to deviations of Spain's CPI in ‡ation and output growth from their respective targets. By comparing y dif f and y peseta dif f , we can isolate how the fact that Spain belongs to EMU a¤ects its macroeconomic behavior in relation to the rest of the currency area.  not reported here but available upon request, we found that the counter-factual peseta nominal interest rate would have been above the observed euro nominal interest rate for most of the sample period (with di¤erences of up to a hundred basis points in annual terms in certain periods). This would have led to a substantial appreciation of the peseta against the euro, which would have reduced the relative price of goods imported from EMU. Since the latter account for a non-negligible share of the Spanish CPI, it follows that the peseta appreciation would have helped contain in ‡ationary pressures while causing only small reductions in GDP growth.

Concluding remarks
Since the launch of the Euro, the evolution of the Spanish economy has been remarkably di¤erent from that of the rest of the Euro area. Both the rate of growth of GDP and the in ‡ation rate have been systematically higher in Spain, and so has been the rate of employment creation. These di¤erentials stem partially from the ongoing process of convergence and from the integration of …nancial markets with strong repercussions in an economy that has resorted traditionally to foreign funds to …nance a substantial gap between domestic savings and investment. These di¤erences deserve a more careful scrutiny in the context of models combining high and low frequency ‡uctuations in the data.
Leaving aside these long term features there are shorter-term di¤erences in the macroeconomic performance of Spain vis-à-vis the EMU. These di¤erences can be explained by a combination of idiosyncratic shocks and the unequal speed of adjustment of prices and quantities arising from structural asymmetries between the two economies. BEMOD is designed to capture these features, thanks to the fact that the economic structure of Spain and the rest of EMU are modelled with the same degree of detail. Econometric estimation reveals however signi…cant di¤erences both in the series of historical shocks and in the structural parameters. The data is informative regarding the parameters governing price and wage dynamics as well as the stochastic processes of the shocks. The estimation reveals some moderate di¤erences in these parameters across the two countries. In particular we …nd that nominal rigidities are somewhat smaller in Spain, especially for tradables goods prices, while wage indexation is much higher than in its EMU partners.
The model …t is good and the variance decomposition suggests that Spain-speci…c costpush shocks play a very important role in accounting for the dynamics of in ‡ation in Spain, but not in the rest of EMU where it is mainly driven by shocks from the rest of the World. The variance decomposition of Spanish value added is more balanced, with both Spain-speci…c demand and productivity shocks playing an important role. The historical contribution of shocks con…rms these results for more speci…c episodes, uncovering the main reasons behind the evolution of the in ‡ation and growth di¤erentials.
The estimated model is used to perform three counterfactual exercises. First, we …nd that growth and in ‡ation di¤erentials between Spain and the rest of EMU would have been di¤erent during prolonged periods should the Spanish economy have experienced the same shocks as those estimated for its EMU partners. This is particularly true for the evolution during the early years of the Euro. Second, the structural speci…cities of the Spanish economy account for a non-negligible proportion of the volatility of di¤erentials in CPI in ‡ation. In particular, the lower degree of nominal price and wage rigidities estimated for the Spanish economy seems to have played an important role, by amplifying the e¤ect of common shocks such as oil price shocks. Finally, EMU membership seems to have had a non-negligible e¤ect on the volatility of growth and in ‡ation di¤erentials. In a version of BEMOD in which Spain is able to set its own monetary policy, we show that an independent monetary authority would have hypothetically pursued di¤erent output-in ‡ation trade-o¤s for most of the sample period. In particular, during the 2002-2006 period the Spanish monetary authorities would have hypothetically cooled down in ‡ationary pressures at the cost of (slightly) slower economic growth.
The speci…cation and estimation of BEMOD is an ongoing project, since it is a model built for active use in the analysis of the various issues a¤ecting the Spanish economy and the Eurozone over time. There are many issues in the research agenda regarding both the theoretical structure and the estimation process. Some of them are the introduction of credit frictions, as well as a public investment block. On the empirical side, further robustness checks regarding the set of observables are due and we also plan to extend the estimation to other parameters that have been calibrated in the current version. Finally, although the model contains a wide range of exogenous shocks, there is room for improvement on this front too.