Abstract
The paper analyses the stabilising potential of simple fiscal policy rules for a small open economy in monetary union in a 2-region DSGE model with nominal and real rigidities. We consider simple fiscal instrument rules for government purchases, transfers, and consumption, labour and capital taxes in analogy to interest rate rules in monetary policy. The paper finds a dichotomy in the welfare effects of fiscal policy for liquidity-constrained and intertemporal optimising households, i.e. policies enhancing the welfare of one group tend to reduce the welfare of the other one. The moderate average welfare gains from optimal policy contrast with potentially large welfare losses from non-optimal policy. Fiscal rules that respond to employment fluctuations may be preferred to fiscal rules responding to indicators of price competitiveness, because optimal policy corresponds more closely to the idea of countercyclical stabilisation in the former case. The simulations also emphasise the crucial impact of the budgetary closure rule on the welfare consequences of fiscal business-cycle stabilisation.
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Notes
The EU’s internal market and public procurement policies have weakened the case for the alternative assumption of strong/full home bias in government consumption.
We only consider fiscal policy rules that do not discriminate between domestic and foreign goods. Adao et al. (2009) show that adjustable differentiated sales taxes on domestically produced and imported goods eliminate the welfare costs of losing monetary autonomy under certain conditions. Such origin-based tax discrimination appears incompatible with internal market rules, however.
In this sense, the policy rules are similar to price-level as opposed to inflation targeting in monetary policy, which is discusses by Cournède and Moccero (2009). However, an important difference is that ToT stationarity in a small member country of monetary union, i.e. taking export import prices as given, requires stationarity of the domestic price level. In an economy with flexible nominal exchange rate, ToT stationarity is compatible with non-stationarity of domestic prices as long as the combination of domestic prices and the nominal exchange rate is stationary.
Kumhof and Laxton (2009) use inflation adjustment costs instead of price adjustment costs in their discussion of simple fiscal policy rules for open economies. Contrary to the standard price adjustment costs implying purely forward-looking inflation dynamics, inflation adjustment costs are a mechanism to generate endogenous inflation persistence.
The countries are AUT, BEL, ESP, FIN, GRC, IRL, NLD and PRT. The focus on this group of early EA members is motivated by the fact that these countries have already more than one decade of EA history to quantify the role of asymmetric shocks.
Kirsanova et al. (2007) also illustrate that there are other features than liquidity constraints, namely increasing endogenous inflation persistence, that increase the welfare costs of cyclical fluctuations and the potential gain from stabilisation policy, because fiscal/monetary stabilisation can dampen the persistence-driven overshooting of price/wage adjustment in response to shocks.
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Acknowledgments
We thank the anonymous referee, Davide Furceri, Robert King, Apostolos Serletis, the guest editors Georgios Kouretas and Athanasios Papadopoulos, the editor George Tavlas, and participants of the 16th Annual Conference on Macroeconomic Analysis and International Finance for helpful comments and suggestions.
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Vogel, L., Roeger, W. & Herz, B. The Performance of Simple Fiscal Policy Rules in Monetary Union. Open Econ Rev 24, 165–196 (2013). https://doi.org/10.1007/s11079-012-9258-0
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DOI: https://doi.org/10.1007/s11079-012-9258-0