Fiscal devaluation in the euro area: A model-based analysis

Abstract

In 2014 all ECB publications feature a motif taken from the €20 banknote.NOTE: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily refl ect those of the ECB. Sandra GomesBank of Portugal; e-mail: sandra.cristina.gomes@bportugal.pt Pascal JacquinotEuropean Central Bank; e-mail: pascal.jacquinot@ecb.int Massimiliano PisaniBank of Italy; e-mail: massimiliano.pisani@bancaditalia.it AbstractWe assess the effects on trade balance of a temporary fiscal devaluation enacted by Spain or Portugal by simulating EAGLE, a large-scale multi-country dynamic general equilibrium model of the euro area. Social contributions paid by firms are reduced by 1 percent of GDP for four years and are financed by increasing consumption tax. Our main results are the following. First, the Spanish trade balance improves by 0.5 percent of GDP, the (before-consumption tax) real exchange rate depreciates by 0.7 percent and the terms of trade deteriorate by 1 percent. Second, similar results are obtained in the case of Portugal. Third, the trade balance improves when the fiscal devaluation is enacted also in the rest of the euro area, albeit to a lower extent than in the case of unilateral (country-specific) implementation. Fourth, quantitative results crucially depend on the degree of substitutability between domestic and imported tradables. JEL Classification Numbers: F32; F47; H20.Keywords: fiscal devaluation; trade deficit; dynamic general equilibrium modeling. ECB Working Paper 1725, August 2014 1Non-technical Summary A country belonging to a monetary union cannot rely on nominal exchange rate devaluation to increase, in presence of nominal price rigidities, its international relative price competitiveness and, hence, improve in the short run its trade balance. An alternative way to increase the short-run international price competitiveness is through a temporary "fiscal devaluation", defined as the combination of two fiscal measures: the decrease in social contributions paid by employers and the increase in consumption tax.The reduction in employers' social contributions reduces the unit labor costs. As long as the latter are passed-through into final prices, the improvement in price competitiveness favors exports and reduces imports. The reduction in contributions is financed by increasing the consumption tax, which is also a destination-based tax. As such, it raises the after-tax price of domestic and imported goods uniformly, but not the price of exported goods. Overall, the combination of lower unit labor costs and higher consumption tax decreases the price of exported goods and increases the after-tax relative price of the imported good.In this paper we assess the trade balance improvement in correspondence of a tem- lower than in the case on unilateral devaluation, as tradable goods produced in the rest of the euro area are now more competitive than in the case of unilateral devaluation. Ex-

Government expenditure composition and fiscal policy spillovers in small open economies within a monetary union

“…18 The parameters governing the trade linkages between the model blocs are based on a mix of national accounts data (for the volume of trade) and input-output tables (for the composition, consumption or investment, of traded goods and the bilateral components of trade) available from the countries' respective national statistical agencies. 19 The remaining parameters in the model are either based on country-specific empirical evidence, where available, or kept consistent with the original model which uses standard values, prevalent in the literature (see Gomes et al (2012) ). The values of the calibrated steady-state ratios and parameters for both countries are reported in Table 1-4 .…”

“…This allows for a comprehensive treatment of cross-border macroeconomic interdependences and spillovers. The model has been used for euro area policy analysis of structural reforms ( Gomes et al, 2012 andGomes et al, 2013 ), accession to the monetary union ( Brzoza-Brzezina et al, 2014 ), and fiscal devaluations ( Gomes et al, 2016 ). Here only a brief overview of the main features of the EAGLE is provided, with the reader referred to Gomes et al (2012) for a detailed description of the original model.…”

“…The euro area monetary policy rule takes into account the size of each bloc in the area and takes the following form (see Gomes et al (2012) ):…”

“…Moreover, as the definitions of the real effective exchange rates use double weighting, this implies that for a large country, they are not materially affected by developments in a small country. For the precise definitions of the double weighting scheme see Gomes et al (2012) . 16…”

“…This implies that if there is an increase in public investment in the EMU (e.g., the so-called Juncker Plan ) that is not evenly distributed across countries, then countries with close trade linkages may still benefit from spillovers. 4 To investigate the issues above, we extend the fiscal policy analytical capabilities of a global DSGE model, the EAGLE ( Gomes et al, 2012 ), by introducing complementarity of government and private consumption and allowing government investment to be productive, as outlined above. Moreover, we allow for a direct import content of government spending, which takes into account that some government purchases in small open economies are on imported goods.…”