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When does financial integration matter for fiscal policy in a currency union? A welfare-based approach

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  • Koenig, Gilbert
  • Zeyneloglu, Irem

Abstract

We use a two-country new open economy macroeconomics model describing a currency union with imperfect financial integration. We assume that household preferences are biased towards the goods produced within the country. We use this setup to show how the degree of financial integration and the home bias affect the welfare efficiency of fiscal policy. This is particularly important for the implications of a fiscal policy launched by a member of the euro zone where the home bias is in a decreasing trend due to higher goods market integration and where there are explicit efforts to enhance financial integration. The results show in particular how the effects of an increasing financial integration on the impact of a fiscal policy can be mitigated or amplified by a decreasing home-product bias. Moreover, under certain conditions, the degree of financial integration has no effect on the welfare efficiency of fiscal policy despite its non-negligible effects on the components of welfare.

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Bibliographic Info

Article provided by Elsevier in its journal Economic Modelling.

Volume (Year): 27 (2010)
Issue (Month): 3 (May)
Pages: 620-630

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Handle: RePEc:eee:ecmode:v:27:y:2010:i:3:p:620-630

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Web page: http://www.elsevier.com/locate/inca/30411

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Keywords: New open economy macroeconomics Fiscal policy Financial integration Home bias;

References

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  1. Jacob A. Frenkel & Assaf Razin, 1987. "The Mundell-Fleming Model a Quarter Century Later: A Unified Exposition," IMF Staff Papers, Palgrave Macmillan, vol. 34(4), pages 567-620, December.
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  3. Carre, Martine & Collard, Fabrice, 2003. "Monetary union: A welfare based approach," European Economic Review, Elsevier, Elsevier, vol. 47(3), pages 521-552, June.
  4. Obstfeld, Maurice & Rogoff, Kenneth S., 1995. "Exchange Rate Dynamics Redux," Scholarly Articles 12491026, Harvard University Department of Economics.
  5. Christian Pierdzioch, 2004. "Financial Market Integration And Business Cycle Volatility In A Monetary Union," Scottish Journal of Political Economy, Scottish Economic Society, vol. 51(3), pages 422-442, 08.
  6. Francis E. Warnock, 1998. "Idiosyncratic tastes in a two-country optimizing model: implications ; of a standard presumption," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 631, Board of Governors of the Federal Reserve System (U.S.).
  7. Sutherland, Alan, 1996. " Financial Market Integration and Macroeconomic Volatility," Scandinavian Journal of Economics, Wiley Blackwell, Wiley Blackwell, vol. 98(4), pages 521-39, December.
  8. Senay, Ozge, 1998. "The Effects of Goods and Financial Market Integration on Macroeconomic Volatility," The Manchester School of Economic & Social Studies, University of Manchester, University of Manchester, vol. 66(0), pages 39-61, Supplemen.
  9. Christian Pierdzioch, 2003. "Capital Mobility and the Effectiveness of Fiscal Policy in Open Economies," Kiel Working Papers 1164, Kiel Institute for the World Economy.
  10. Caselli, Paola, 2001. "Fiscal consolidation under fixed exchange rates," European Economic Review, Elsevier, Elsevier, vol. 45(3), pages 425-450, March.
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