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Budgetary-Neutral Fiscal Policy Rules and External Adjustment

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Abstract

Large external imbalances and fragile fiscal positions have emerged as major policy challenges for the euro area in the financial crisis. The paper analyses whether shifting government purchases between tradable and non-tradable goods could help reduce external fluctuations without large swings in the overall fiscal stance. The policy rules considered are budgetary-neutral in the sense that the overall level of government expenditure is kept constant. We compare the policy rules to fiscal devaluation as a strategy to reduce external imbalances and find that state-dependent changes in the composition of government purchases between tradables and non-tradables can stabilise excessive fluctuations in the event of economy-wide supply and demand shocks. Contrary to fiscal devaluation, the expenditure-shifting rule faces a trade-off between stabilising domestic activity and enhancing household welfare, on the one hand, and reducing excessive fluctuations in external positions, on the other hand. The excess volatility of domestic variables associated less volatility in the external position implies welfare losses for standard specifications of household utility. The adverse welfare effect is absent in the case of fiscal devaluation.

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Notes

  1. Rabanal and Tuesta (2013) show that the distinction between tradable and non-tradable goods is important to understand real exchange rate fluctuations and that non-tradable technology shocks explain about one third of real exchange rate volatility.

  2. The small-country setting differs from other research that has focused on fiscal policy in monetary unions of two large/symmetric countries (e.g., Beetsma and Jensen 2004; Kirsanova et al. 2007; Ferrero 2009).

  3. Kumhof and Laxton (2013b) use inflation adjustment 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.

  4. 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.

  5. The emphasis on simple instrument rules owes to their practical advantages over fully optimal policy solutions. Contrary to the fully optimal policy solution, simple rules use a limited set of information. Compliance with simple rules is, consequently, easier to monitor than the commitment to fully optimal policy, and the feasibility of compliance monitoring mitigates the credibility/time-consistency problem. Credibility is crucial, because it determines the policy maker’s ability to anchor the expectations of households and firms.

  6. The relatively low value is common in the literature that estimates open economy sticky price models because it explains higher volatility of relative prices than relative quantities (Lubik and Schorfheide 2006; Rabanal 2009).

  7. The countries are AUT, BEL, ESP, FIN, GRC, IRL, NLD and PRT. The focus on this group of smaller countries among the 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.

  8. To keep the analysis concise, we only show the results for output gap stabilisation. Results for a policy rule reacting to the employment gap are similar to the results for the policy rule responding to the output gap.

  9. More detailed impulse responses, including separate IRFs for the frictionless economy, can be found in the related working paper (Hohberger et al. 2013).

  10. Here, we combine the different policy instruments (Table 3) in one Figure.

  11. Previous contributions measuring welfare effects of fiscal policy relative to non-stabilisation and in per cent of steady state consumption include Ferrero (2009), Evers (2012), Kumhof and Laxton (2013b) and Vogel et al. (2013).

  12. The different illustrated parameter ranges in Fig. 4 are chosen to assume that both policies responds to a 0.5 percentage-point decline in the trade balance gap by a tax (expenditure) shift from labour to consumption tax (T to NT goods) of approximately 1 percentage point (1 percentage point of GDP).

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Acknowledgments

The authors would like to thank in particular the editor-in-chief George S. Tavlas, an anonymous referee, Francesco Marchionne, and Marika Cioffi for very helpful comments as well as participants of the International Conference on ‘The Financing and the Adjustment Sharing of External Imbalances’ (Ancona), the Annual International Conference on Macroeconomic Analysis and International Finance (Rethymno), the Annual European Economics and Finance Society Conference (Berlin), the Annual Congress of the European Economic Association (Gothenburg), and the annual meeting of the German Economic Association (Düsseldorf) for helpful suggestions.

Disclosure

The views in this paper are personal and should not be attributed to the European Commission.

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Authors and Affiliations

  1. University of Bayreuth, Bayreuth, Germany

    Stefan Hohberger & Bernhard Herz

  2. DG Economic and Financial Affairs, European Commission, Brussels, Belgium

    Lukas Vogel

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  1. Stefan Hohberger
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Correspondence to Stefan Hohberger.

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Hohberger, S., Vogel, L. & Herz, B. Budgetary-Neutral Fiscal Policy Rules and External Adjustment. Open Econ Rev 25, 909–936 (2014). https://doi.org/10.1007/s11079-014-9314-z

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