The Performance of Simple Fiscal Policy Rules in Monetary Union
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The Performance of Simple Fiscal Policy Rules in Monetary Union Lukas Vogel & Werner Roeger & Bernhard Herz
Published online: 30 September 2012 # European Union 2012
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. Keywords Fiscal policy . Monetary union . Simple instrument rules . Welfare JEL classification E37 . E62 . F41
1 Introduction This paper investigates the potential of simple fiscal policy rules to stabilise cyclical fluctuations and reduce the welfare cost of supply and demand shocks in monetary The views in this paper are personal views and should not be attributed to the European Commission. L. Vogel (*) DG Economic and Financial Affairs, European Commission, CHAR 14/233, 1049 Brussels, Belgium e-mail: [email protected] W. Roeger DG Economic and Financial Affairs, European Commission, CHAR 14/004, 1049 Brussels, Belgium B. Herz VWL 1, Department of Law and Economics, University of Bayreuth, 95440 Bayreuth, Germany
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union. The focus is on the stabilisation of asymmetric shocks at the level of small member states, which are not stabilised by the reaction of the common monetary policy to area-wide variables, so that fiscal policy remains the (only) macroeconomic policy tool available. The paper, hence, reconsiders a classical question of the currency union literature, namely the importance and potential of fiscal policy to stabilise asymmetric shocks at the level of the member countries. We address the question in a setting that differentiates between alternative fiscal instruments (government purchases, transfers, and consumption, labour and capital taxes) and applies the idea of simple instrument rules to the conduct of fiscal policy. We focus the discussion on the potential of simple fiscal instrument rules to stabilise and reduce the welfare costs of temporary demand and supply shocks, i.e. business cycle fluctuations around a sustainable long-term growth path. The paper analyses temporary changes in fiscal variables in reac
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