By Alexandre Lucas Cole, Chiara Guerello and Guido Traficante
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.
This paper addresses an important policy question, yet I am not ready to advocate the policy prescription. The reason is that I find symmetric two-country models too restrictive, especially when you want to talk about the Eurozone, where economies differ a lot in size and bilateral trade balance matters only in few cases. Build at least a three-country model with economies differing in size (and import propensity). You lose the convenience of the two-country symmetry, but you gain relevance.