Journal of Policy Modeling 35 (2013) 9921013

Available online at www.sciencedirect.com

Reserve nancing and government infrastructure
investment: An application to China
Yin Germaschewski

Department of Economics, Indiana University, Bloomington, IN 47405, United States

Received 8 March 2013; received in revised form 7 June 2013; accepted 29 July 2013
Available online 19 August 2013
Abstract
This paper proposes a novel nancing scheme, reserve nancing, for government infrastructure investment
in China. A two-sector open economy model explores the consequences and policy implications of a surge in
infrastructure investment nanced by international reserves. The results show that reserve nancing, coupled
with a managed oat exchange rate system, can maintain the countrys fast growth rate while mitigating scal
pressure on local governments. Productive infrastructure capital stimulates domestic demand, reducing the
countrys dependence on exports. To promote growth and maintain price stability, three factors are critical:
return on infrastructure, swift scal adjustment, and rapid infrastructure nancing.
2013 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.
JEL classication: O11; O23; F43; H54
Keywords: Government investment; Fiscal nancing; Infrastructure; Open economy
1. Introduction
The slowing Chinese economy will struggle to achieve its minimum growth target of 7.5%
this year. This is due to a nationwide real estate downturn, slowing imports, a broad deterioration
in business conditions and declining consumer condence. In recent years, China had been the
leader in world economic growth, with annual growth rates averaging 9.5%. A Chinese downturn,

Correspondence to: Department of Economics, Indiana University, Wylie Hall 105, Bloomington, IN 47405, United
States. Tel.: +1 812 855 8453.
E-mail address: yinhu@indiana.edu
0161-8938/$ see front matter 2013 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.
http://dx.doi.org/10.1016/j.jpolmod.2013.07.001
Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013 993
Fig. 1. The ination rate and the accumulation of foreign exchange reserves in China. Ination rate is the annual change
on consumer price index. Source: The National Bureau of Statistics of China. Chinese foreign exchange reserves include
foreign exchange, reserve position in the IMF and SDRs at end-period. Source: IMF, International Financial Statistics.
(a) The Ination Rate in China. (b) Chinas foreign exchange reserves.
even as Europe contends with a sovereign debt crisis and the US attempts to jump-start its recessed
economy, could unnerve international investors with fears of a second global recession.
As a main driver of Chinas economic engine, government infrastructure investment has
reduced the poverty rate, boosted productivity in the private sector, and most importantly, spurred
private investment when the economy faces downward pressure. The Chinese government is
responding to signs of economic slowdown by initiating a new round of infrastructure investment
in roads, ports, airports, worth an estimated $160 billion. Though the hope is that this invest-
ment in infrastructure will foster growth and bolster a faltering economy, it fails to consider three
potential problems: ination, infrastructural bubble and scal nancing.
Despite the governments anti-inationary efforts, prices in China have in recent years increased
signicantly (see Fig. 1(a)). Climbing food, property and energy prices pushed the August 2011
consumer price index up 6.5% over 2010, and the actual numbers could be higher than ofcially
reported.
1
High ination endangers Chinas competitiveness in the world market and poses a
threat to social stability as ination further widens the income gap between rich and poor.
The Chinese government has substantially increased its infrastructure investment in the recent
past, but the demand for infrastructure services outpaces the supply due to continuous population
growth and urbanization.
2
In addition, most infrastructure expenditures are concentrated on big
cities, neglecting the rural areas that need the investment the most.
3
The infrastructure in large
1
Chinese price index has longstanding methodological problems, the ofcially reported price index tends to underes-
timate the actual ination.
2
Inadequate supply of infrastructure is common in China. According to an article from Shanghai Daily on September
7, 2012: Shanghai may face a shortage of water supply if the population continues to soar. The current capacity of the
citys water supply was about 16 million tons per day, which is able to cover the demand of 26 million people. However,
once the population reaches 30 million, the demand would rise to 18 million tons per day, exceeding the current capacity.
And Shanghai will hit 30 million in about seven years. Moreover, tens of millions of migrants have left the Chinese
countryside for the cities, increasing the need for power and transportation. See Ljungwall (2005), Qin, Cagas, Quising,
and He (2006), and Cao, Wang, and Wang (2009) for more details.
3
China has experienced a nationwide energy shortage of 3040 million kilowatts of power last summer, with the
worst shortfalls in southern and eastern suburban and rural regions, where most factories are located. Power shortages
have forced many factories to shut down their production lines, and some nished products did not meet the necessary
specications due to the lack of a steady supply of power.
994 Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013
Table 1
Comparison of key infrastructure supply.
Infrastructure services China U.S. S. Korea Malaysia S. Africa
Electric power consumption (kWh per capita, 2009) 2631 12,914 8900 3614 4532
Paved roads (% of total roads, 2008) 53.5 67.4 78.5 N/A N/A
Improved water source, rural (% of rural population, 2010) 85 94 97 99 79
Improved water source, urban (% of urban population, 2010) 98 100 100 100 99
Internet users (per 100 people, 2011) 38.4 78.2 81.5 61 20.9
Mobile cellular subscriptions (per 100 people, 2011) 73 106 109 127 127
Motor vehicles (per 1000 people, 2009) 47 802 355 350 162
Data come fromWorld Development Indicators (the World Bank). N/A implies that no data is available for this particular
infrastructure service. Years vary due to the availability of data.
cities is similar to that found in wealthier nations, while the one found in the countryside closely
resembles that observed in Third World countries. Table 1 compares Chinas provisions of key
infrastructure services with the US, South Korea, Malaysia and South Africa. The infrastructure
capital stock in China lags behind these countries, especially in rural areas, which still suffer
from a severe infrastructure deciency. Thus, additional investment is urgently needed in order
to achieve sustained rapid growth. On the other hand, continuous investing in urban areas would
result in falling marginal returns on public investment, and can potentially result in an oversupply
of infrastructure, dampening the growth effects of public investment.
In the past, most Chinese infrastructure investment was nanced by undisciplined bank lending,
leading to the amassing of huge debts by local governments. The Chinese government countered
this trend by tightening restrictions on bank lending and reducing the amount of money available
for loans. Despite those measures, a new fear has arisen that more liquidity problems in the future
will cause local governments to default on their debts, precipitating a wave of nonperforming loans
at Chinese banks. A surge in infrastructure investment would make it harder for the government
to stabilize prices and resolve local government debt issues.
To address this ongoing policy dilemma that pits infrastructure investment against controlling
ination, promoting growth and preventing debt accumulation, this paper proposes a novel nan-
cingscheme, reverse nancing. The Chinese government has accumulated a tremendous amount of
international reserves over the past few years, mostly U.S. dollar assets (see Fig. 1(b)).
4
However,
China lacks diversied channels through which to preserve the value of its international reserves.
The book value for some of these assets has fallen signicantly since 2000 due to a devaluation
of the U.S. dollar, and their interest earnings are quite low. Rather than leaving them to earn low
interest, investing Chinas more than $3 trillion in foreign exchange reserves in infrastructure
projects would diversify the nations portfolio. Reserve nancing would not pile further scal
burdens on already-stressed local governments, nor would it unleash a torrent of bank lending.
Rather, skillful use of reserve nancing could allow the government to reignite growth without
revving up ination.
4
The composition of Chinese foreign exchange reserves is presently regarded as a top state secret, so there is no detailed
ofcial report available. It is commonly estimated that 60%of Chinese foreign exchange reserves are in U.S. dollars and
bonds, especially U.S. long-term Treasury Bonds. According to a United States Treasury Department report, in October
2009, China held $798.9 billion of U.S. Treasury Bonds, $479.8 billion of long-term agency bonds, $24.5 billion of
long-term corporate bonds and $108 billion in the U.S. stock market, adding up to $1.4 trillion.
Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013 995
The contribution of infrastructure investment to economic growth has been studied exten-
sively (e.g. Angeletos & Panousi, 2009; Aschauer, 1989; Becerril-Torres, lvarez-Ayuso, & Del
moral Barrera, 2010; Chatterjee, Sakoulis, & Turnovsky, 2003; Glomm & Ravikumar, 1994;
Mamatzakis, 2007; Salinas-Jimnez, 2004; Wang, 2002). The analyses in these studies, how-
ever, were mostly conducted in closed-economy setups, mainly focused on taxation nancing
options: either lump-sum or distortionary taxes. In contrast to the existing literature on gov-
ernment infrastructure investment, this research deviates from the previous work in two ways.
First, the nancing instrument used in this research goes beyond the conventional nancing
choices. Second, a dynamic general equilibrium open economy model is developed to assess the
macroeconomic consequences of using reserves to pay for a 50% increase in public infrastructure
investment. A two-sector framework allows us to investigate the policy implications on many
important variables in the economy, such as sectoral output and real exchange rate dynamics,
which cannot be addressed in one-sector closed-economy models.
Briey, in the reserve nancing model, higher infrastructure investments are paid in full by
international reserves, so that 55% of the countrys foreign exchange reserves are spent gradually
over a few years. Government lump-sum transfer payments are adjusted over time to peg the
long-run ination rate at the governments target level. Instead of a xed peg, the government
adopts a more exible exchange rate systema managed oatand manages the path of the
exchange rate in an effort to reconcile a sharp and sustained increase in infrastructure investment
with continuously lower ination.
5
Three factors are critical in regard to achieving a ne balance
between stimulating the economy and stabilizing prices: return on public infrastructure, speed of
scal adjustment and speed of infrastructure nancing.
Return on government infrastructure investment matters a great deal for the expansionary
effects of infrastructure investment. Spending more money on infrastructure that has an adequate
supply sharply reduces the return on public investment. An extremely low return (i.e. the net rate
of return on infrastructure is 3% or less) can be harmful under current nancing scheme, because
the cost of investment: loss in international reserves and interest earnings on these reserves, can
outweigh the benet. So long as the return is not exceedingly low, the accumulation of public
infrastructure capital generates a positive wealth effect, which propels a consumption boom and
reduces the time people spend working. Concurrently, rising productivity and efciency increase
the return on private investment. Both factors redirect the nations growth from exports to stronger
domestic demand, a goal that Chinese policymakers have pursued for a long time. But wishing it
were so is not enough, and problems may arise during the transitional periods.
In the short run, the desire to consume more in response to an anticipated rise in income leads
to an ex ante excess demand for nontraded goods. Since nontradables have to be produced at
home, more resources are needed in the nontradable sector, and the relative price of nontradables
has to rise to entice a shift of resources. The weak spot appreciation of the nominal exchange
rate is not sufcient to counterbalance the increase in the relative price of the nontraded goods,
and price levels then jump up on impact. Sluggish scal adjustment fails to anchor ination
expectations. The rate of ination mounts by more than four percentage points, according to
the typical calibration for the Chinese economy, and stays above the governments target rate
in the short and medium terms. Seeing higher ination, agents immediately reduce their current
5
Chinas current exchange rate is predetermined by the central government, and the general consensus on the world
market is that the Chinese currency is undervalued (see Zhang &Wan, 2008). Continued pressure exists fromthe rest of the
world urging China to revalue its currency. A more exible exchange rate policy would reduce the currency appreciation
pressure from the rest of the world, and be more compatible with the nations current economic structure.
996 Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013
demand for money, creating a liquidity shortage, which draws savings away from investment.
Private investment contracts temporarily, falling 1.63%.
The transitional dynamics highlight the crucial role played by the speed of scal adjustment
in determining the path of ination. A quick reduction in lump-sum transfer payments favorably
affects the scal decit, solidly anchoring ex ante ination expectations and strengthening the pull
of long-run fundamentals to immediately deliver a disinationary outcome. The anticipation of
lower ination creates an incentive to accumulate real money balances, leading to a sharp decline
in ination ex post despite a strong increase in aggregate demand. In cases where the government
reduces the lump-sum transfer payments to their long-run stationary level in fteen years instead
of thirty-ve years, the rate of ination falls to 4.07% initially and continues to decrease.
Regrettably, it has often proven difcult for the government to implement a quick scal adjust-
ment. An easy antidote for high ination in the short run is to sell more international reserves than
the amount needed for infrastructure nancing each period. Under plausible conditions, pumping
19% of extra reserves into the economy signicantly lowers the rate of currency depreciation,
which far outweighs the rate of ination in the nontradable sector. The overall rate of ination
then falls to 0.67% on impact and stays below its initial level thereafter. In addition, if the long-
run ination target is set at a lower rate than the ination initially prevailing in the economy,
the immediate decrease in ination will be even more pronounced. A big surge in productive
public infrastructure investment, combined with rapid scal adjustment or fast nancing, would
not worsen the local governments budget or exert any inationary pressure. Output, consumption
and private investment rise shortly after the infrastructure expansion, while the rate of ination
falls on impact and remains subdued.
In the rest of the paper, Section 2 lays out the two-sector open economy model and its main
characteristics. Section 3 then calibrates the model to match the Chinese economy. Section 4
reports the numerical results and examines key policy issues. Section 5 addresses some important
policy concerns, while Section 6 discusses policy implications and concludes the paper.
2. The model
The core model is an open economy that produces nontraded goods and composite traded goods.
The two-sector framework highlights the real exchange rate dynamics and sectoral asymmetry
that are crucial for the analysis of different policy responses. There are no trade taxes, and all world
market prices equal unity, so domestic prices of traded goods are set by the exchange rate e. The
Chinese government has strict restrictions on private capital ows, so capital account is assumed to
be closed. The model incorporates several features needed to shed light on the policy implications
of infrastructure expansion: elastic labor supply, costly investment adjustment, distorting taxes
levied against consumption and capital income, and a managed oat exchange rate system.
2.1. Technology and the supply side
Technology is identical in both the tradable and nontradable sectors. Production functions take
the CES functional form.
Q
n
= aZ

b
1
K
(
n
1)/
n
n
+ L
(
n
1)/
n
n

n
/(
n
1)
(2.1)
Q
T
= aZ

b
2
K
(
T
1)/
T
T
+ L
(
T
1)/
T
T

T
/(
T
1)
(2.2)
Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013 997
where b
1
and b
2
are share parameters, and
i
is the elasiticity of substitution (i = T, n). Q
i
is
the output in sector i. Both nontraded goods and traded goods are produced by capital K and
labor L. Government infrastructure Z increases productivity in the same manner as the Hicks-
Neutral technological progress. Capital is mobile ex ante, but sector-specic ex post. Labor is
intersectorally mobile.
Firms in both sectors are perfectly competitive. With perfect competition and constant return
to scale in capital and labor, the sectoral demands for capital and labor are
K
n
=
C
n
r
(w, r
n
)Q
n
aZ

K
T
=
C
T
r
(w, r
T
)Q
T
aZ

L
n
=
C
n
w
(w, r
n
)Q
n
aZ

L
T
=
C
T
w
(w, r
T
)Q
T
aZ

(2.3)
Competitive rms earn zero prot in equilibrium, which links goods prices to factor prices.
Letting P
n
denote the relative price of nontraded goods to traded goods (P
n
then is the inverse of
the real exchange rate), the two zero-prot conditions are
P
n
=
C
n
(w, r
n
)
aZ

1 =
C
T
(w, r
T
)
aZ

(2.4)
where C
i
is the cost function of producing aZ

units of output; w is the wage rate determined by

basic market forces; r
i
is the capital rental in sector i; and all measured in units of the traded good.
2.2. The private agents optimization problem
Consider an open economy inhabited by a large number of identical, innitely lived consumers
who are endowed with perfect foresight. All economic decisions in the private sector are made by
a representative agent who derives utility from consumption of traded and nontraded goods, from
the liquidity services generated by holdings of domestic currency, and from leisure. Strict capital
controls prevent the private agent from borrowing abroad or purchasing foreign assets. Domestic
money and physical capital are therefore the only vehicles available for wealth accumulation.
Preferences take the CES-CRRA functional form
U =

U(C
n
, C
T
)
11/
1 1/
+h
1
(M/P)
11/
1 1/
h
2
L
1+1/
s
1 + 1/

e
t
dt (2.5)
where
U(C
n
, C
T
) = [
0
C
(1)/
T
+
1
C
(1)/
n
]
/(1)
is linearly homogeneous CES aggregator function; h
1
and h
2
are constant;
0
and
1
are share
parameters; is the elasticity of substitution between traded and nontraded consumption goods;
is pure time preference rate; is the intertemporal elasticity of substitution; is Frisch elasticity
of labor supply to the real wage, holding the marginal utility of consumption constant.
The private agent solves the optimization problem in two stages. In the rst stage, C
n
and
C
T
are chosen to maximize U(C
n
, C
T
), subject to the budget constraint P
n
C
n
+ C
T
= E. E is the
total expenditure measured in units of the traded good. The optimal choices of C

n
and C

T
give an
998 Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013
indirect utility function V (P
n
, E) =
(E/c(P
n
))
11/
11/
, with c(P
n
) = (

0
+

1
P
1
n
)
1/(1)
. Therefore,
the exact consumer price index can be written as P = ec(P
n
), and the rate of ination is
= +

P
n
P
n
(2.6)
where is the rate of currency depreciation, dened as e/e, and =

1
P
1
n
(

0
+

1
P
1
n
)
1
is
the consumption share of the nontraded goods.
In the second stage, the private agent chooses consumption, real money balances, investment
and leisure to maximize

(E/c(P
n
))
11/
1 1/
+ h
1
(m/c(P
n
))
11/
1 1/
h
2
L
1+1/
s
1 + 1/

e
t
dt (2.7)
subject to
m = r
T
K
T
+ r
n
K
n
+ wL
s
+ T (1 + v
1
)E (1 + v
2
)P
k

I
n
+
v(I
n
/K
n
)
2
K
n
2
+I
T
+
v(I
T
/K
T
)
2
K
T
2

m (2.8)

K
n
= I
n
K
n
(2.9)

K
T
= I
T
K
T
(2.10)
where m = M/e is the real money balance measured in units of the traded good; T is a lump-sum
transfer from the government; I
i
is private investment in sector i; is the capital depreciation
rate;
v(I
i
/K
i
)
2
K
i
2
is the investment adjustment cost function in sector i; v
1
and v
2
are the value-
added taxes (VAT) on consumption and investment, respectively. The endogenous labor supply
L
s
introduces wealth effects to the model. Physical capital is produced by combining one unit of
an imported input with b
n
units of nontraded inputs, thus, the supply price of capital P
k
is given
by P
k
= 1 + b
n
P
n
.
The budget constraint, (2.8), states that savings increase over time whenever income exceeds
spendingon consumption and investment; (2.9) and (2.10) describe the rate of capital accumulation
in the nontradable and tradable sectors.
The necessary conditions for an optimum consist of

E
c(P
n
)

1/
=
1
(1 + v
1
)c(P
n
) (2.11)
h
2
L
1/
s
=
1
w (2.12)

2
=
1
(1 + v
2
)P
k

1 + v

I
n
K
n

(2.13)

3
=
1
(1 + v
2
)P
k

1 + v

I
T
K
T

(2.14)
Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013 999

1
= ( + )
1
h
1
(m/c(P
n
))
1/
c(P
n
)
(2.15)

2
=
2
( + )
1

r
n
(1 + v
2
)P
k
v
2

I
n
K
n

2
+ (1 + v
2
)P
k
v

I
n
K
n

I
n
K
n

(2.16)

3
=
3
( + )
1

r
T
(1 + v
2
)P
k
v
2

I
T
K
T

2
+ (1 + v
2
)P
k
v

I
T
K
T

I
T
K
T

(2.17)

1
,
2
and
3
are multipliers attached to the constraints seen in (2.8)(2.10). (2.11) and (2.12)
state that the marginal utility of consumption equals the shadow price of wealth multiplied by the
price of consumption, and that the marginal rate of substitution between leisure and consumption
equals the real wage. (2.13) and (2.16) dene a Tobins q model of investment in the nontradable
sector. (2.14) and (2.17) dene a corresponding Tobins q model in the tradable sector. (2.15) is
simply a Euler equation.
2.3. The public sector
The public sector comprises the scal authority and the monetary authority. The balance sheet
of the Central Bank is

M =

DC + e

R, so the changes of money supply depend on domestic

credits DC and the accumulation of foreign exchange reserves R. The governments ow budget
constraint is given by
m = P
z
I
z
+ T rR m v
1
E v
2
P
k
[I
n
+
v(I
n
/K
n
)
2
K
n
2
+I
T
+
v(I
T
/K
T
)
2
K
T
2

R (2.18)
where I
z
is the government investment in infrastructure; P
z
is the supply price of infrastructure,
which is given by P
z
= 1 + b
z
P
n
. Similar to private capital stock, infrastructure is produced by
combining one unit of an imported input with b
z
units of nontraded inputs.
The rate of infrastructure accumulation is

Z = I
z

z
Z (2.19)
As indicated by (2.18), the government has ve sources of revenue: interest income on its
international reserves; capital gains on reserves; money printing; consumption and investment
VAT revenues; and ination tax. Expenditure consists of the lump-sum transfer payments and
infrastructure investment. The government sells foreign exchange reserves to pay for the increase
in net infrastructure investment each period.

R = P
z
f (I
z

z
Z), f 1 (2.20)
where
z
is the rate of infrastructure depreciation, and f measures the speed of nancing. If f > 1, the
government is selling more reserves than the amount needed to pay for infrastructure investment;
1000 Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013
if f = 1, reserves are sold to cover the exact cost of investment each period. Substituting for

R in
(2.18) gives
m = P
z
I
z
+ T rR m P
z
f (I
z

z
Z) v
1
E v
2
P
k

I
n
+
v(I
n
/K
n
)
2
K
n
2
+I
T
+
v(I
T
/K
T
)
2
2
K
T

(2.21)
The government has its own target rate of ination. In order to achieve the goal, the long-run
transfer payments have to be xed at T

= rR

+ v
1
E

+ v
2
P

k
(I

n
+ I

T
) P

z
I

z
, so
that the rate of ination will be pegged at
*
in the long run. The lump-sum transfer payment then
adjusts over time toward the long-term stationary level at T
*
according to the rule

T = (T

T (t)), > 0 (2.22)

where is the speed of scal adjustment.
2.4. Market-clearing conditions
Temporary equilibrium in the economy is dened by the equality of demand and supply in the
labor market and the nontraded goods market. Both markets clear when
L
s
= L
n
+ L
T
(2.23)
Q
n
= D
n
(P
n
, E) + b
n

I
n
+
v(I
n
/K
n
)
2
K
n
2
+I
T
+
v(I
T
/K
T
)
2
K
T
2

+ b
z
I
z
(2.24)
where D
n
(P
n
, E) is the Marshallian demand function for consumer goods. (2.24) states that total
output in the nontradable sector is equal to the demand for nontraded consumption goods plus the
demand for nontraded inputs used in producing new capital goods and infrastructure.
2.5. Dynamic system and solution technique
The solution to the model generates a dynamic system with ve state variables, K
n
, K
T
, Z,
R, and T, and three jump variables, m, I
n
, and I
T
. (2.8) and (2.21) are linked to solve for E as a
function of endogenous variables, so that E is not a core variable in the dynamic system. At the
time the government increases its investment in infrastructure, it adopts a managed oat exchange
rate system, so is not a policy variable anymore and is instead determined by the basic market
forces, but the government occasionally intervenes to inuence the path of the exchange rate in
an attempt to maintain price stability, especially when the economy is experiencing sharp and
continuous increases in aggregate demand.
(2.16) and (2.17) together with the consolidated public sector budget constraint (2.21), capital
accumulation in both sectors ((2.9) and (2.10)), rate of infrastructure accumulation (2.19), infra-
structure nancing scheme (2.20), and the adjustment process for government lump-sum transfer
payments (2.22) form a system of eight differential equations. Details of the solution technique
Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013 1001
Table 2
Model calibration.
Parameter Calibration
Preference
Consumption share of the nontraded good 0.4
Elasticity of substitution between traded and nontraded consumption goods 0.5
Time preference rate 0.1
Frisch elasticity of labor supply 0.3
Intertemporal elasticity of substitution 0.25
Technology
Share of nontraded inputs in the production of capital 0.35
Share of nontraded inputs in the production of infrastructure 0.8
Q-elasticity of investment spending 3
Cost share of capital in the nontradable sector
n
k
0.45
Cost share of capital in the tradable sector
T
k
0.35
Rate of depreciation for private capital 0.06
Rate of depreciation for infrastructure capital
z
0.1
Elasticity of substitution between labor and capital in sector i
i
0.5
Fiscal parameter
Initial ratio of foreign exchange reserves to GDP R/Y 0.45
Initial ratio of infrastructure investment to GDP P
z
I
z
/Y 0.05
Net rate of return on infrastructure investment rz
o

z
0.25
Ratio of money balance to consumption 0.1
Ination rate 5%
World interest rate r 3%
Consumption value-added tax rate v
1
15%
Investment value-added tax rate v
2
15%
Speed of lump-sum transfer adjustment 0.09
Speed of infrastructure nancing f 1
can be found in the long version of the paper available at http://mypage.iu.edu/yinhu. Analytical
solutions are difcult to obtain, so I rely on numerical simulations.
3. Model calibration
The model is calibrated at an annual frequency to characterize the effects of government
infrastructure investment that extends several decades into the future. Parameter calibrations are
summarized in Table 2. Most parameters are calibrated to match the data from China. The longer
version of the paper discusses the data and empirical estimates that justify the value assigned to
each parameter. In this paper, we focus on the parameters that strongly affect the outcomes of a
surge in public investment.
Intertemporal elasticity of substitution () matters a great deal not only for the short-run
dynamics, but also for the long-run stimulative effect of public investment. There is an abundance
of empirical literature estimating the value of . Most estimates place between 0.2 and 0.5 for
emerging markets.
6
Chinas savings rate is very high, 40% on average, so 0.25 is chosen for the
6
Garcia-Cicco, Pancrazi, and Uribe (2010) estimated to be equal to 0.5 for emerging markets; Guvenen (2006) further
showed that is low for the poor; Reinhart, Ogaki, and Ostry (1996) computed the mean value of to be 0.25 for the
poorest countries.
1002 Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013
baseline model. For comparison purpose, two additional values are considered, one is 0.5, the
other is 1.2.
The share of domestically produced infrastructure () is critical in determining the effectiveness
of government scal expansion. Results in Section 5 show that policy package that encourages
greater utilization of nontraded inputs in the production of infrastructure can bring in substantial
efciency gains for the economy, giving rise to a prolonged period of expansion. In the baseline
model, is calibrated at 0.8 because infrastructure is mostly produced at home.
The initial gross rate of return on infrastructure (rz
o
) and infrastructure investment to GDP ratio
jointly determine the output elasticity of infrastructure ().
7
The larger the rz
o
, the greater the ,
which implies that the diminishing return on infrastructure falls slowly when infrastructure capital
accumulates. The value of rz
o
is in line with empirical estimations in developing countries.
8
Two more policy parameters that will have strong inuence on the extent to which policy will
matter for the path of ination are the speed of lump-sum transfer adjustment () and the speed of
infrastructure nancing (f). 0.09 is set to in the baseline case, which implies that the lump-sum
transfer payment adjusts gradually toward its long-run stationary value. f is set to unity initially,
so that the government sells reserves at the speed that exactly pays for the cost of investment
each period. Given these parameters importance, an extensive sensitivity analysis is conducted
on both of them.
4. Numerical solutions
The goal the government wants to achieve is to increase infrastructure capital by 50% in the
next few years. Foreign exchange reserves are used to pay for the investment cost each period,
and the government adopts a managed oat exchange rate system. It is useful, before launching
into transitional dynamics, to examine the long-run stationary outcomes of the model.
4.1. The long-run stationary equilibrium
Table 3 shows a simulation of the long-run equilibrium. The long-run effects of an increase in
infrastructure investment are signicant and favorable. Productive public infrastructure investment
greatly enhances efciency and productivity in the private sector, giving rise to strong economic
expansion and rapid growth without putting stress on the government budget.
Both the initial return on infrastructure and the intertemporal elasticity of substitution play
important roles in determining long-run stationary outcomes. With a small value of rz
o
(i.e.
rz
o
= 0.15, and net return is 5%), the return on infrastructure investment falls quickly when
7
According to the specication of production functions, the ratio of infrastructure investment to output (P
z
I
z
/Y) is
initially equal to /(
z
rz
o
). Even though this ratio has risen in recent years, it had been quite low over the past few years,
so (P
z
I
z
)/Y is set to the average value of this ratio over the past twenty years. See Chow (1993) and Demurger (2001) for
more details.
8
World Development Report (1994) used a cost-benet analysis estimating the return for World Bank projects. The
result showed that the average return on road projects is 29% and 11% for electricity projects. Canning and Bennathan
(2000) stated that microeconomic cost-benet studies may potentially miss the positive externalities to infrastructure, so
they used an aggregate production function to calculate the rate of return to infrastructure that captures the total social
rate of return to infrastructure. Their estimation has found that the gross rate of return on electricity generating capacity in
China is 54%, and on paved roads is generally high, around 40%, assuming the rate of depreciation is 7%. See Tables 6 and
7 in Canning and Bennathan (2000). Isaksson (2010) used a panel data set estimating the net return on hard infrastructure.
The average return in developing countries varies from 48% to 57%.
Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013 1003
Table 3
The long-run stationary outcomes.
Values E/c(P
n
) m/c(P
n
) K
n
K
T
I L
s
Q
n
Q
T
Y T/Y
o
R/Y
o
P
n
Baseline 4.66 4.66 5.28 2.82 4 2 9.49 6.32 7.62 2.56 24.77 1.13
rz
o
=0.15 1.01 1.01 4.37 1.81 3.04 0.28 6.14 3.28 4.46 3.06 24.9 0.49
=1.2 8.56 8.56 8.66 6.55 7.57 1.4 13 10.18 11.33 1.99 24.77 1.13
=0.6 4.72 4.72 3.99 3.47 3.81 2 8.15 6.99 7.68 2.59 24.77 1.13
=0.4 1.47 1.47 1.14 1.43 1.3 0.6 2.47 2.57 2.53 0.88 8.32 0.38
=0.55 4.71 4.71 5.16 3.1 4.14 2.02 9.25 6.48 7.64 2.56 24.77 1.16

n
=1.5 5.46 5.46 13.24 4.07 8.48 2.87 10.7 7.59 8.85 2.38 24.74 1.3

T
=1.5 5.68 5.68 6.64 12.56 9.71 3.09 10.85 8.07 9.21 2.32 24.8 0.99
=1 3.66 3.66 4.42 1.87 3.09 2.87 8.59 5.34 6.67 2.71 24.77 1.13

*
=3% 4.66 8.47 5.28 2.82 4 2 9.49 6.32 7.62 2.73 24.77 1.13
Note: the baseline case is using the calibrated parameter values in Table 2. All entries below the second row report the
long-run stationary outcomes when one parameter value deviates from the baseline calibration. E/c(P
n
) represents real
consumption; m/c(P
n
) is real money stock; T/Y
o
is the ratio of lump-sum transfer payments to initial GDP; R/Y
o
is the
ratio of foreign exchange reserves to initial GDP. All numbers are percentage deviations from their initial values.
infrastructure capital accumulates, so the stimulative effects of higher public investment are sig-
nicantly weakened. Expansionary scal policy that focuses exclusively on the size of investment
spending regardless of its low return may not achieve its goal as a scal stimulus. On the contrary,
a large value of not only fosters private consumption and investment spending, but also increases
the time spent working in response to the rising real wage. The overall expansion is quantitatively
signicant. Output increases by 11.33% instead of 7.62%, when = 025.
More insights can be drawn from the two-sector framework. For instance, large elasticity
of substitution between capital and labor in the nontradable sector (
n
= 1.5) strengthens the
crowding-in effects of public infrastructure investment on private investment, so that the economy
enjoys more consumption and leisure. When infrastructure investment mostly uses traded inputs
( = 0.4), it boosts the tradable sector, leaving the nontradable sector less affected. The overall
efciency gains are relatively small. Government policy should therefore promote greater use of
nontraded inputs in the production of infrastructure. The value of also determines the long-run
supply price of infrastructure capital.
9
The smaller the , the cheaper the infrastructure capital,
so less international reserves are needed to cover the cost of higher investment.
4.2. Transitional dynamics
Fig. 2 plots the solution paths using the parameter calibration in Table 2. The dominant effect
of a one-time, unanticipated, permanent increase in public infrastructure investment is the positive
wealth effect, which raises the consumption for both traded and nontraded goods and reduces the
hours worked, pushing up the real wage. The agents desire to consume more in response to the
anticipated rise in productivity and efciency results in an ex ante excess demand for nontraded
goods. The relative price of nontradables has to rise to meet the demand. The capital account is
closed, so the increase in aggregate demand cannot be reconciled by private capital inows. A
spike in the relative price of nontraded goods is not counterbalanced by the weak spot appreciation
of the nominal exchange rate. The overall price level then rises immediately after the reform.
9
According to the specication of the model, in a stationary equilibrium, P
z
=1/(1 ).
1004 Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013
Fig. 2. Transitional dynamics for the baseline model. Solid lines: percentage deviations frominitial values; dashed lines:
percentage deviations across steady states. The solution paths for ination rates are expressed in actual percentage points.
(For interpretation of the references to color in text, the reader is referred to the web version of the article.)
Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013 1005
The gradual scal adjustment as shown in Fig. 2 fails to anchor ex ante ination expectation, and
excess demand in the nontradable sector aggravates inationary pressure. Anticipating a higher
rate of ination, agents reduce their demand for real money balances ex post, further worsening
ination. As a result, the rate of ination increases by four percentage points on impact and stays
above the governments target rate of 5% in the short and medium terms.
The two-sector model highlights the asymmetric dynamics between the tradable and nontrad-
able sectors over short-term horizons. The rise in the relative price of nontraded goods raises the
real product wage in the tradable sector, causing it to release labor which is absorbed in the non-
tradable sector as the real product wage falls. The jump in employment in the nontradable sector
shifts up the marginal product schedule for capital, spurring rms to invest more. The demand
curve in the nontradable sector moves to the right, while the transfer of labor from tradable to
nontradable sector shifts the supply curve to the left in the tradable sector, both of which pull in
the same direction of an appreciation of the real exchange rate. Since real appreciation is in favor
of the nontradable sector, the supply boom is concentrated there. By contrast, output shrinks in
the tradable sector. The temporary contraction of tradable production outweighs expansion in the
nontradable sector, and total output falls slightly in the short run.
Effects on private investment depend on several factors. Real appreciation lowers the real
supply price of capital in the nontradable sector and raises it in the tradable sector. Given the
large share of imported capital goods in the production of private capital (small ), the real cost of
capital falls signicantly in the nontradable sector but rises a little in the tradable one. If these were
the only factors at work, then total private investment would rise. However, the decrease in real
money balances creates a liquidity shortage, which draws savings away from capital accumulation.
Private investment decreases by 1.63% on impact, but quickly rebounds thereafter.
Even though reserve nancing does not immediately lead to a disinationary outcome, it
reduces the countrys dependence on the tradable sector and strengthens domestic demand. With
a managed oat exchange rate system, the path of the nominal exchange rate is not fully manip-
ulated by the government, and is, instead, largely determined by basic market forces and agents
expectations, which permit the exchange rate to uctuate more freely, and pave the way for greater
exchange rate exibility in the future.
4.3. Return on infrastructure, scal adjustment and nancing speed
In theory, productive infrastructure investment can foster growth and buoy the economy. The
prerequisite for this benecial effect is that the return on infrastructure is not extremely low. In
addition, scal adjustment and nancing speed matter a great deal for the path of ination.
4.3.1. Return on infrastructure investment
The Chinese policymakers have to be careful on how they carry out the stimulus plan, because
the macroeconomic consequences of reserve nancing of infrastructure investment are sensitive
to the return on the investment. Pouring all the money into urban infrastructure projects that have
adequate supply can lead to falling marginal return, and may even worsen the economic downturn.
Depending on the productivity of public infrastructure capital, the negative wealth effect from
rising government spending and selling international reserves could dominate the positive wealth
effect brought by higher infrastructure investment, resulting in small or even negative effects on
output. In addition, the quality of investment matters both quantitatively and qualitatively for
long-termgrowth effects. Some projects in China were built in a very short period of time without
going through a series of strict safety checks. Collapsing bridges, roads and dams has been a
1006 Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013
Fig. 3. Solution paths in an economy with weakly productive infrastructure: rz
o
=0.15 (red solid lines) and corresponding
percentage deviations across steady states (red dashed horizontal lines). For comparison purpose, responses from the
baseline model (blue dot-dashed lines) and corresponding percentage deviations across steady states (blue dot-dashed
horizontal lines) are also presented. (For interpretation of the references to color in this gure legend, the reader is referred
to the web version of the article.)
serious problem in China, which can also make government investment contractionary at longer
horizons.
Fig. 3 plots the responses when infrastructure capital is weakly productive: rz
o
= 0.15 (red solid
lines), and repeats the solution paths in Fig. 2 (blue dot-dashed lines), for comparison. The expan-
sionary effect on public investment hinges crucially on the return on infrastructure, which is an
important factor not only for determining the long-run growth effect of infrastructure investment,
but also for the short-run dynamics. A small initial return suggests that the diminishing return on
infrastructure falls quickly when infrastructure capital builds up. It is more protable to accumu-
late capital and labor in the early stages of reform when the marginal products of inputs increase
signicantly, inducing agents to work and accumulate capital in response to higher expected
returns in the short run. Demand for capital and labor then rises more in the nontradable sector
and falls less in the tradable sector compared to the baseline case, boosting private investment.
The positive wealth effect generated by higher public infrastructure investment is thus greatly
weakened: the initial increase in real consumption is merely 0.09% and the reduction of hours
worked is by 0.03% only, according to the model calibration. The overall revenue gains from VATs
are small, thus, lump-sum transfer payments have to be cut further in order to peg the long-term
ination rate at the governments target rate. The effect of stimulus spending depends in large part
Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013 1007
Fig. 4. Solution paths in an economy with quick scal adjustment: =0.25 (red solid lines) and corresponding percentage
deviations across steady states (red dashed horizontal lines). For comparison purpose, responses fromthe baseline model
(blue dot-dashed lines) and corresponding percentage deviations across steady states (blue dot-dashed horizontal lines)
are also presented. (For interpretation of the references to color in this gure legend, the reader is referred to the web
version of the article.)
on the size of its return. Policies that aim only at accumulating more infrastructure capital stocks
may have very limited impact on growth.
4.3.2. The role of scal adjustment
The analysis in Section 4.2 drives home the point that sluggish scal adjustment cannot stabilize
prices by pinning down the rate of ination, so the natural policy response is to rapidly adjust the
lump-sumtransfer payments. Fig. 4 contrasts the solution paths of ination, real money balances
and lump-sum transfer payments from two cases: a rapid scal adjustment (red solid line) and
sluggish scal adjustment (blue dot-dashed line).
When the government reduces the lump-sum transfer payments to their long-run stationary
levels in about fteen years instead of thirty-ve years, ination in the tradable sector and the
overall rate of ination jump down immediately and continue to decrease. Anticipating lower
future ination, agents immediately start accumulating money. This causes a sharp decline in the
price level despite a strong increase in aggregate demand. Well-anchored ination expectations
trigger large decreases in ination ex post. The rate of ination falls to 4.07%, and the demand
for money rises to 9.31% at the time the reform starts. Even though the rate of ination in the
nontradable sector rises on impact, it is far outweighed by the long-run deationary pull. A
quick cut of government lump-sum transfer payments favorably affects the reduction of the scal
decit and strengthens the pull of long-run fundamentals to deliver an immediate, large decline in
ination. A surge in productive infrastructure investment combined with rapid scal adjustment
will not exacerbate inationary pressure, and can be most effective in terms of productivity growth
and price stability.
4.3.3. Financing speed
In reality, it is often difcult or politically toxic for the government to rapidly cut lump-sum
transfer payments; sometimes, policymakers cannot withstand the pressure from the public and,
1008 Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013
Fig. 5. Solution paths in an economy with fast nancing: f =1.35 (red solid lines) and corresponding percentage deviations
across steady states (red dashed horizontal lines). For comparison purpose, responses from the baseline model (blue dot-
dashed lines) and corresponding percentage deviations across steady states (blue dot-dashed horizontal lines) are also
presented. (For interpretation of the references to color in this gure legend, the reader is referred to the web version of
the article.)
eventually, are forced to slow down the reduction. The side effect of sluggish scal adjustment is
the short-run high ination that policymakers are opposed to. Alternatively, the government can
accelerate the speed of infrastructure nancing in order to tame ination.
By setting f = 1.35, the government sells more reserves than are needed to cover the cost of
infrastructure investment each period. Instead of spending 55% of the nations total international
reserves throughout the reform, the government could sell an additional 19%, which would sig-
nicantly lower the rate of currency depreciation.
10
Fig. 5 plots the solution paths from the speedy
nancing scenario (red solid line), and from the baseline model (blue dot-dashed line). The over-
all rate of ination falls considerably at time t = 0 and remains subdued thereafter, lowering the
opportunity cost of holding money. The immediate increase in the demand for real money balances
is more than 25%.
Previous simulations were created under the assumption that the governments long-run target
rate of ination was set at the same level as the initial rate. We relax this assumption by setting
the long-run ination target at 3%. Table 4 shows that a lower long-run ination target positively
affects the ex ante ination expectation. Expected ination, though not dependent of the ination
target, is certainly anchored by the target, leading to even lower ination ex post. The results also
indicate that intertemporal elasticity of substitution () has important implications for how the
public infrastructure investment affects the economy in the short run. The quantitative changes of
the demand for real money are much less when takes a small value, because the current demand
for money is less sensitive to its future return.
10
Even after additional reserve sales, China still holds substantial amount of international reserves, about 25% of the
nations GDP, much more than the optimal reserve level suggested by Ben-Bassat (1980), Obstfeld, Shambaugh, and
Taylor (2010), Jeanne and Rancire (2011) and many others. The longer version of the paper has extensive discussions
on the potential consequences and implications of Chinese reserve sales.
Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013 1009
Table 4
Impact effects on demand for real money balances, the price level, and the rate of ination in the fast nancing scenario.

*
M/P(0) e(0)

P
n
(0) P(0) (0)
n
(0) (0)
0.05 25.2 29.27 21.05 25.98 3.11 6.34 0.67 0.25
31.19 35.13 27.53 32.09 0.75 8.08 2.78 0.5
54.14 58.65 51.26 55.69 0.97 9.57 4.41 1.2
0.03 27.81 31.96 23.74 28.68 3.63 5.82 0.15 0.25
34.52 38.57 30.97 35.53 1.19 7.64 2.34 0.5
64.21 69.01 61.63 66.05 0.42 9.03 3.87 1.2
Note: Parameter values are the same as the baseline case except f =1.35 and
*
=3%.
Both the speed of the scal adjustment and speed of nancing can effectively combat short-run
ination, but each works through different channels. A quick cut in lump-sum transfer payments
strengthens the favorable effect of higher infrastructure investment on the scal decit, and ulti-
mately, achieves price stability. Rapid nancing ghts short-run ination by sufciently lowering
the rate of currency depreciation, so that the sharp decrease in the rate of currency depreciation
counterbalances the inationary pressure that stems from the ex ante excess demand for nontraded
goods. In regard to the Chinese economy, our results have shown that policy response given by
speedy infrastructure nancing is the most appropriate way to control ination.
5. Some policy concerns
The main objective of an increase in government infrastructure investment is to reignite the
nations fast economic growth. In addition to the return on infrastructure, the proportion of non-
traded inputs in the production of infrastructure capital () matters for the expansionary effect of
this scal stimulus. Fig. 6 compares the transitional dynamics using different values for . In the
case where = 0.4, some of the observations merit attention:
When infrastructure investment mostly uses tradable inputs (red solid line), both the short-run
expansion in the nontradable sector and contraction in the tradable sector are much smaller
when compared to the baseline model (blue dot-dashed line), producing small consumption
and output responses to increases in government investment.
In response to the small efciency gain, the desire to increase consumption is weak, so the rate
of ination in the nontradable sector is moderate; while the rate of currency depreciation falls
on impact, lessening the short-run inationary pressure.
The utilization of nontraded inputs in the production of infrastructure strongly conditions policy
outcomes. Without the support from policies that encourage greater use of nontraded inputs in
producing infrastructure capital, additional investment in infrastructure may be of little help in
stimulating the economy.
Another important policy concern regarding government infrastructure investment is its effect
on private investment. Table 3 has pointed out that public investment spurs private capital accu-
mulation in the long run regardless of parameter variations, but what about its short-term impact?
Will public investment temporarily crowd out private investment? If the answer is positive, then
is it possible to prevent this short-run crowding-out effect?
1010 Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013
Fig. 6. Solution paths in an economy with =0.4 (red solid lines) and corresponding percentage deviations across steady
states (red dashed horizontal lines). For comparison purpose, responses from the baseline model (blue dot-dashed lines)
and corresponding percentage deviations across steady states (blue dot-dashed horizontal lines) are also presented. (For
interpretation of the references to color in this gure legend, the reader is referred to the web version of the article.)
Table 5 suggests that there are several factors inuencing private investment: the share of the
nontraded inputs in the production of capital (), the q-elasticity of investment spending () and
the intertemporal elasticity of substitution (). A small implies that the real cost of capital falls
sharply in the nontradable sector, but rises a little in the tradable sector when the relative price
of nontraded goods increases, which strengthens the crowding-in effect of public investment on
Table 5
Impact effects on private investment.
=0.35 =0.55
I
n
I
T
I I
n
I
T
I
3 10.15 12.55 1.63 7.33 14.18 3.27 0.25
12.6 9.55 1.11 9.73 11.89 0.92 0.5
15.92 5.64 4.74 12.99 8.92 2.19 1.2
8 19.69 22.9 2.41 15.04 25.01 4.69 0.25
22.45 19.06 0.91 17.71 22.69 2.2 0.5
26.98 13.28 6.09 21.95 19.41 1.57 1.2
Note: All entries are percentage deviations from the initial values.
Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013 1011
private investment. The incentive for immediate capital accumulation battles against the liquidity
shortage, which discourages investment in the initial phase of the reform. The response pattern of
private investment hinges on the value of intertemporal elasticity of substitution. According to the
model specication, when is small (i.e. 0.25), the decrease in the demand for money signicantly
raises the marginal utility of money, causing the private agent to temporarily substitute away from
investment toward the rebuilding of his real money stock. Private investment is crowded out in the
short run. It is therefore crucial for the policymakers to anchor ination expectation in order to
prevent a contraction in private investment. The anticipation of lower ination in future can sharply
weaken the competing asset effect due to the decrease in real money stock, so that an increase in
public investment immediately and continuously motivates private capital accumulation.
Table 5 also illustrates the importance of . The small value of indicates that the cost of
adjusting investment is high and that changes in investment are costly, which prevents rms from
drastically varying their investment spending. As the adjustment occurs over time, the duration
of rise in the nontradable sector and fall in the tradable sector is also longer compared to the case
when = 8. These effects are quantitatively signicant.
6. Policy implications and concluding remarks
Chinas economy continues to show signs of slowing, which calls for immediate economic
stimulus, and infrastructure investment is ideal to counteract the economic downturn. However,
by pumping up infrastructure spending, the country runs the risk of worsening ination and local
government debt. This study contributes to the large literature on public infrastructure investment
by proposing a well-designed novel nancing scheme and highlighting the key ndings and policy
implications. The framework the paper developed accommodates two scenarios that are pertinent
to the current Chinese economy, where excess infrastructure investment exists in some areas and
decient investment is common in others.
Spending part of the nations enormous international reserves to ramp up infrastructure invest-
ment will release the funding pressure that most Chinese local governments have encountered in
recent years. Productive infrastructure capital will boost domestic demand, reduce the countrys
dependence on exports, and eventually, transform the countrys economy from being export-
driven to becoming more dependent on domestic demand, enabling more sustainable, long-term
growth. In the currency market, the government adjusts the path of the exchange rate to stabilize
prices when infrastructure investment surges, and a managed oat exchange rate regime is more
compatible with the nations economic structure.
In order to foster growth and maintain price stability, the following three factors are critical:
return on infrastructure, speed of scal adjustment and speed of nancing. In the past, government
investment in infrastructure successfully helped the nation to sail through several regional and
global nancial crises, but most investments concentrated on urban areas, and very little money
was spent on suburban and rural areas with the greatest infrastructure shortages. Continuous invest-
ment in big cities may potentially lead to an oversupply of infrastructure. Moreover, corruption,
bad planning and poor quality construction can sharply reduce the return on public investment,
hindering the benecial effects of government investment at both short and long horizons. Policy
package that intends to revive the sluggish economy through infrastructure investment has to
ensure that the return on infrastructure is sufciently high (i.e. the net return is more than 3%
according to model calibration). In addition, the growth effect of government investment would be
greater if scal stimulus were combined with policies that promote large utilization of nontraded
inputs in the production of infrastructure capital.
1012 Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013
Our analysis has pointed out the danger of high rate of ination in the early phase of the scal
stimulus due to the ex ante excess demand for nontraded goods. In response to the government
stimulus and the anticipated rise in income, the agent desires to increase consumption, which
drives up the relative price of nontradables, putting upward pressure on the rate of ination.
The rise in ination not only reduces the demand for money, but also depresses private capital
accumulation. China has experienced periods of high rate of ination in recent past, creating
potential threat to the nations stability. It is highly likely that policymakers will scale down their
investment plans if inationary pressure mounts. Price stabilization policy is therefore essential
for the success of infrastructure expansion, and a rapid scal adjustment can be an effective policy
to combat this short-run ination. Such a cut in government lump-sum transfer payments anchors
the ination expectation and quickly reduces the scal decit, which triggers a sharp increase in
the demand for real money balances. As a result, the rate of ination falls to 4.07% on impact, and
continues to decrease. Public investment immediately and signicantly boosts private investment.
Unfortunately, it is generally impractical for the government to quickly reduce lump-sum
transfer payments because a large portion of the population heavily depends on these government
transfers. The best policy response to short-run ination is to speed up the pace of infrastructure
nancing. By selling 19% extra reserves, the government could sufciently lower the rate of
currency depreciation, so that the overall rate of ination decreases in the short run and remains
below the governments target level.
Government investment in infrastructure has been the primary driver of Chinas economic
development, and can continue to serve as an engine of future growth. But policymakers have
to carry out the stimulus plan carefully and effectively. Results have shown a risk of short-run
ination and crowding-out on private investment if scal adjustment or nancing are done slowly,
and a possibility of long-run contraction if infrastructure capital is unproductive.
An interesting extension would be to estimate the maximum level of reserves the Chinese
government could sell to pay for its scal stimulus without putting any risks to the nations
economy under relevant scenarios, and at the same time, the government could still be able to
buffer external shocks using the reserves that have been retained. This analysis will provide high
level of practical relevance for policymakers.
Acknowledgements
This paper is based on chapter two of my Ph.D. thesis written at Indiana University. I am
especially grateful to Edward Bufe for constant advice and encouragement. I also wish to thank
Robert Becker, Volodymyr Lugovskyy, and audiences at Eastern Economics Association Con-
ference for helpful suggestions. Comments from four anonymous referees and editors greatly
improve the paper.
References
Angeletos, G.-M., &Panousi, V. (2009). Revisiting the supply side effects of government spending. Journal of Monetary
Economics, 56, 137153.
Aschauer, D. A. (1989). Is public expenditure productive? Journal of Monetary Economics, 23, 177200.
Becerril-Torres, O. U., lvarez-Ayuso, I. C., & Del moral Barrera, L. E. (2010). Do infrastructures inuence the conver-
gence of efciency in Mexico? Journal of Policy Modeling, 32, 120137.
Ben-Bassat, A. (1980). The optimal composition of foreign exchange reserves. Journal of International Economics, 10,
285295.
Y. Germaschewski / Journal of Policy Modeling 35 (2013) 9921013 1013
Canning, D., & Bennathan, E. (2000). The social rate of return on infrastructure investments. Policy Research Working
Paper Series 2390 The World Bank.
Cao, S., Wang, X., &Wang, G. (2009). Lessons learned fromChinas fall into the poverty trap. Journal of Policy Modeling,
3129831307.
Chatterjee, S., Sakoulis, G., & Turnovsky, S. J. (2003). Unilateral capital transfers, public investment, and economic
growth. European Economic Review, 47, 10771103.
Chow, G. C. (1993). Capital formation and economic growth in China. The Quarterly Journal of Economics, 108, 809842.
Demurger, S. (2001). Infrastructure development and economic growth: An explanation for regional disparities in China?
Journal of Comparative Economics, 29, 95117.
Garcia-Cicco, J., Pancrazi, R., & Uribe, M. (2010). Real business cycles in emerging countries? American Economic
Review, 100, 25102531.
Glomm, G., &Ravikumar, B. (1994). Public investment in infrastructure in a simple growth model. Journal of Economic
Dynamics and Control, 18, 11731187.
Guvenen, F. (2006). Reconciling conicting evidence on the elasticity of intertemporal substitution: A macroeconomic
perspective. Journal of Monetary Economics, 53, 14511472.
Isaksson, A. (2010). Public capital, infrastructure and industrial development. United Nations Industrial Development
Organization.
Jeanne, O., & Rancire, R. (2011). The optimal level of international reserves for emerging market countries: A new
formula and some applications. The Economic Journal, 121, 905930.
Ljungwall, C. (2005). State xed investment and non-state sector growth in China. Journal of Policy Modeling, 27,
211229.
Mamatzakis, E. (2007). EUinfrastructure investment andproductivityinGreekmanufacturing. Journal of Policy Modeling,
29, 335344.
Obstfeld, M., Shambaugh, J. C., & Taylor, A. M. (2010). Financial stability, the trilemma, and international reserves.
American Economic Journal: Macroeconomics, 2, 5794.
Qin, D., Cagas, M. A., Quising, P., & He, X.-H. (2006). How much does investment drive economic growth in China?
Journal of Policy Modeling, 28, 751774.
Reinhart, C., Ogaki, M., & Ostry, J. (1996). Saving behavior in low- and middle-income developing countries: A
comparison. IMF Staff Papers, 43, 3871.
Salinas-Jimnez, M. d. M. (2004). Public infrastructure and private productivity in the Spanish regions. Journal of Policy
Modeling, 26, 4764.
Wang, E. C. (2002). Public infrastructure and economic growth: Anewapproach applied to east Asian economies. Journal
of Policy Modeling, 24, 411435.
Zhang, Y., & Wan, G. (2008). Correcting Chinas trade imbalance: Monetary means will not sufce. Journal of Policy
Modeling, 30, 505521.