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Risk Sharing and Moral Hazard with a Stability Pact

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  • Roel Beetsma
  • Henrik Jensen

Abstract

We show how a stability pact based on deficit sanctions eliminates the exacerbation of debt accumulation that may arise from monetary unification. Moreover, by making sanctions contingent upon the economic situation of countries, the stability pact provides for risk sharing. Differences in initial debt levels, however, reduce the scope for unanimous support for a pact. We introduce also endogenous „fiscal discipline“ whose unobservability leads to moral hazard in its provision. If countries are ex ante identical, it is nevertheless optimal to make sanctions at least to some extent contingent on countries’ economic situation. However, with cross-country differences in the costs of providing discipline, some countries may oppose such contingency.

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Paper provided by Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics in its series EPRU Working Paper Series with number 99-11.

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Handle: RePEc:kud:epruwp:99-11

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Cited by:
  1. Dury, K. & Pina, A.M., 2000. "Fiscal Policy in EMU: Simulating the Operation of the Stability Pact," Economics Working Papers eco2000/3, European University Institute.
  2. Beetsma, Roel & Jensen, Henrik, 2003. "Contingent deficit sanctions and moral hazard with a stability pact," Journal of International Economics, Elsevier, vol. 61(1), pages 187-208, October.
  3. Alho, Kari, 2002. "The Stability Pack and Inefficiencies in Fiscal Policy Making in EMU," Discussion Papers 715, The Research Institute of the Finnish Economy.

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