To conduct the analysis in a reasonably realistic modelling environment as used in policy institutions, we require a few features: (1) we need a small open economy that is a member of the monetary union; (2) we need a reasonable trade structure that approximates a modern global economy, where countries trade globally and not just within their currency area or a region; (3) we need a sufficient degree of real and nominal frictions, in particular sticky prices and sticky wages; (4) we need the fiscal policy that allows for public investment.
To satisfy these requirements, we use as the basic framework the model developed by Gomes et al. (2010) and Gomes et al. (2012), which features a small open economy in a monetary union, both integrated in a global economy.2 To model the high degree of openness of the Irish economy as an export platform, we use the augmented framework of this model that features import-content of exports (Brzoza-Brzezina et al. (2014)), as this allows us to calibrate a realistic share of trade relative to GDP. The core model features four blocs, each of which is similar to a standard Smets-Wouters model with sticky prices and wages. Two of the blocs are in a monetary union, so that they share the same monetary policy rate and have the nominal exchange rate fixed to unity. The remaining two blocs are the US and the rest of the world. Risk-sharing is imperfect. Households can save in an intra-euro-area bond that is traded between the two blocs constituting the euro area. In addition, households can also hold an international bond (denominated in USD). These features of the core model satisfy conditions (1)-(2) and partly the condition (3), as the framework has the New Keynesian price and wage rigidities.
To satisfy condition (4), we use the augmented version that features public investment by Clancy et al. (2016) and Hickey et al. (2020). We call this our "first" version of the model and features a standard labour market with sticky wages. A more detailed description of this model is provided in Appendix A.3
The second version of the model is otherwise identical, but adds on top of sticky wage setting also search frictions in the labour market and unemployment. This feature is important, because it changes the firms' hiring decision from the frictionless per-period decision to an intertemporal choice. Its importance lies in the fact that if the public capital is productive, then an increase in public capital in the future plays a direct role in hiring in the labour market immediately, because the hiring decision is forward-looking. It is this feature that links the public investment literature (Baxter and King (1993) and Leeper et al. (2010)) with the news shock literature (Beaudry and Portier (2006), Den Haan and Kaltenbrunner (2009), Den Haan and Lozej (2011)). For an example of this linkage in a closed-economy model, see Matusche (2025).
The modelling of this second version of the model with labour market frictions has been based on De Walque et al. (2009) and Gomes et al. (2023). Their framework has been modified for the purpose of this paper to also include import-content of exports, public investment and public capital in the production function. A more detailed description of the model, in particular of its labour market is provided in Appendix B.4
2The core model is known as the EAGLE, which stands for the Euro Area and the GGlobal Economy.
3For full details the reader should refer to Gomes et al. (2012) and Clancy et al. (2016).
4For full details the reader should refer to Gomes et al. (2012) and Gomes et al. (2023).