One Emu Fiscal Policy for the Euro

Abstract

We build a two-country New-Keynesian DSGE model of a Currency Union to study the effects of fiscal policy coordination, by evaluating the stabilization properties and welfare implications of different fiscal policy scenarios. Our main findings are that a government spending rule which targets the net exports gap rather than the domestic output gap produces more stable dynamics and that consolidating government budget constraints across countries with symmetric tax rate movements provides greater stabilization. A key role is played by the trade elasticity which determines the impact of the terms of trade on net exports. In fact, when goods are complements, the stabilization properties of coordinating fiscal policies are no longer supported. These findings point out to possible policy prescriptions for the Euro Area: to coordinate fiscal policies by reducing international demand imbalances, either by stabilizing trade flows across countries or by creating some form of Fiscal Union or both.

Government debt deleveraging in the EMU

“…The model is calibrated 4 following our previous work, Cole, Guerello and Traficante (2016), which mainly follows Ferrero (2009), so we consider the top 5 Eurozone countries, which account for more than 80% of Eurozone GDP and we divide them into the periphery (namely, France, Italy, Spain and The Netherlands), country F, and the core (namely Germany), country H. The size of country H is set according to the relative GDP size to h = 0.4, as Germany accounts for over 35% of Eurozone GDP.…”

“…In the simulations, country F starts with a higher level of government debt-to-GDP, equal to roughly 80%, in line with the average level of government debt-to-GDP for France, Italy, Spain and The Netherlands. The desired fraction of reduction of excess government debt for country F is set for most simulations to γ = 0.05 (with the same average for all other simulations), corresponding to a 5% yearly reduction of excess government and Traficante (2016).…”

“…The sample considered spans at quarterly frequency from 2002 Q1 to 2015 Q3. The correlation between preference shocks follows our previous work, Cole, Guerello and Traficante (2016), where we pick the value that maximizes the simulated correlation between output in the two countries.…”

“…We follow the open economy approach of Galí (2009) in a two-country setting, like in Silveira (2006) 1 . Our model is an extension of our previous work, Cole, Guerello and Traficante (2016), where we follow the specifications of the two-country Currency Union setting of Ferrero (2009), which adapts the approach of Benigno and Woodford (2004), where there are only distortionary taxes as sources of government revenue. Ferrero (2009) follows also the optimal monetary approach of Benigno (2004) in a Currency Union, but with some differences.…”

“…Ferrero (2009) follows also the optimal monetary approach of Benigno (2004) in a Currency Union, but with some differences. Our model in Cole, Guerello and Traficante (2016) adds home bias in consumption (or a degree of openness to international trade), to allow for deviations from Purchasing Power Parity, and targeting rules for fiscal policy, to allow governments to coordinate. Following Hjortsoe (2016) we add a debt-elastic government bond spread and incomplete international financial markets, to account for international financial frictions, to our previous model.…”