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Fiscal Stimulus in a Small Euro Area Economy

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  • Vanda Almeida
  • Gabriela Lopes de Castro
  • Ricardo Mourinho Félix
  • José R. Maria

Abstract

The international economic and financial crisis elicited an intensive debate on fiscal stimulus programmes. Although the topics have been diverse, most of the research is focused on large countries, some of them in autarky. The literature covering small economies is thinner and for those integrated in a monetary union is virtually nonexistent. This paper is a contribution to fill this gap. The discussion draws on a New-Keynesian general equilibrium model introduced in Almeida, Castro and Félix (2008), which features a small euro area economy. Contrary to most of the literature that considers infinitely lived households, the model features stochastic finite lifetime households following Blanchard (1985), which are a source of non-Ricardian behaviour and allow for pinning-down the steady state net foreign asset position endogenously. Since in a small euro area economy monetary policy is not an available business cycle stabilisation tool, the use of fiscal policy to pursue this goal seems the only alternative. The results reveal that permanent government expenditure increases should be avoided, as opposed to temporary stimulus. This outcome is identical to the one obtained in the literature for large economies. Lags in the program implementation and limited credibility can however undermine the objectives of a temporary stimulus. In particular, in financial distress circumstances, under which the stimulus may trigger a hike in the country's risk premium, the effectiveness of the stimulus might be negligible.

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Bibliographic Info

Paper provided by Banco de Portugal, Economics and Research Department in its series Working Papers with number w201016.

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Date of creation: 2010
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Handle: RePEc:ptu:wpaper:w201016

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Cited by:
  1. Vanda Almeida & Gabriela Lopes de Castro & Ricardo Mourinho Félix & Paulo Júlio & José R. Maria, 2013. "Inside PESSOA - A Detailed Description of the Model," Working Papers, Banco de Portugal, Economics and Research Department w201316, Banco de Portugal, Economics and Research Department.
  2. Nikolai Stähler & Carlos Thomas, 2011. "FiMod - a DSGE model for fiscal policy simulations," Banco de Espa�a Working Papers 1110, Banco de Espa�a.

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