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Fiscal Policy as a Stabilisation Device for an Open Economy Inside or Outside EMU

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  • Campbell Leith

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  • Simon Wren-Lewis

Abstract

Extending Gali and Monacelli (2004), we build an N-country open economy model, where each economy is subject to sticky wages and prices and, potentially, has access to sales and income taxes as well as government spending as fiscal instruments. We examine an economy either as a small open economy under flexible exchange rates or as a member of a monetary union. In a small open economy when all three fiscal instruments are freely available, we show analytically that the impact of technology and mark-up shocks can be completely eliminated, whether policy acts with discretion or commitment. However, once any one of these fiscal instruments is excluded as a stabilisation tool, costs can emerge. Using simulations, we find that the useful fiscal instrument in this case (in the sense of reducing the welfare costs of the shock) is either income taxes or sales taxes. In contrast, having government spending as an instrument contributes very little. In the case of mark-up shocks tax instruments which can offset the impact of the shock directly are highly effective, while other fiscal instruments are less useful. The results for an individual member of a monetary union facing an idiosyncratic technology shock (where monetary policy in the union does not respond) are very different. First, even with all fiscal instruments freely available, the technology shock will incur welfare costs. Government spending is potentially useful as a stabilisation device, because it can act as a partial substitute for monetary policy. Finally, sales taxes are more effective than income taxes at reducing the costs of a technology shock under monetary union. If all three taxes are available, they can reduce the impact of the technology shock on the union member by around a half, compared to the case where fiscal policy is not used. Finally we consider the robustness of these results to two extensions. Firstly, introducing government debt, such that policy makers take account of the debt consequences of using fiscal instruments as stabilisation devices, and, secondly, introducing implementation lags in the use of fiscal instruments. We find that the need for debt sustainability has very limited impact on the use of fiscal instruments for stabilisation purposes, while implementation lags can reduce, but not eliminate, the gains from fiscal stabilisation.

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Paper provided by Centre for Dynamic Macroeconomic Analysis in its series CDMA Conference Paper Series with number 0506.

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Date of creation: Nov 2005
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Handle: RePEc:san:cdmacp:0506

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  1. Pierpaolo Benigno & Michael Woodford, 2003. "Optimal Monetary and Fiscal Policy: A Linear Quadratic Approach," NBER Working Papers 9905, National Bureau of Economic Research, Inc.
  2. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  3. Simon Wren-Lewis & Campbell Leith, 2007. "Fiscal Sustainability in a New Keynesian Model," Economics Series Working Papers 310, University of Oxford, Department of Economics.
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