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Optimal Fiscal Simple Rules for Small and Large Countries of a Monetary Union

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  • Paulo Vieira
  • Celsa Machado
  • Ana Paula Ribeiro

Abstract

The recent financial crisis revived the role for debt-stabilizing fiscal policy together with its systematic use in response to business cycle fluctuations. This is of crucial interest for the particular case of a very small country-member of a monetary union, for which domestic shocks produce substantial welfare costs. Extending a standard New Keynesian open-economy model to a heterogeneous country-size monetary union, where very small economies coexist with a large country, this work provides (i) optimal countercyclicality and debt feedback degrees for fiscal policy and (ii) provides insights on how rules should differ in low- and high-debt scenarios, for different-size countries within a monetary union.We conclude that the common interest rate should not significantly react to the union’s aggregate debt, whereas the reaction of fiscal instruments to inflation is also negligible. Instead, public consumption (tax rate) should react negatively (positively) to the level of public debt, while both instruments should react negatively to output gap. In small countries, fiscal policy debt feedback should be stronger than that for a big country under high-debt, but the reverse should occur in a low-debt scenario. Moreover, the reaction of a big (small) country’s fiscal policy to debt should weaken (increase) in high-debt scenarios. High-debt scenarios also optimally require higher (lower)government spending (taxes) feedback on output gap, particularly for small countries. Derivation of optimal simple rules (OSR) for large and very small economies. We take linear feedback rules for the fiscal instruments of each country, as well as for the common nominal interest rate. Feedback parameters on selected variables are optimized such as to maximize the union-wide welfare function (cooperative scenario), yielding OSRs. Policy rules are derived through assuming a cooperative scenario where all agents seek to maximize the union-wide social welfare. Rule parameters are optimized by minimizing the union-wide welfare costs resulting from asymmetric shocks.We adapt Söderlind (1999) and Giordani and SÖderlind (2004) matlab codes to perform simple rules optimization. Results confirm that the stabilization costs for the union as a whole are higher under a high-debt scenario. Moreover, though the performance of OSR is worse than full-optimal policies under commitment, they perform better relative to discretion. In particular, our results point to an active monetary policy and a passive fiscal policy. The interest rate gap responds to both structural variables (output and inflation), and mostly to the union’s average inflation, and fiscal instruments (government spending and the revenue tax rate) react to output gap differences and national public debt. We conclude that the common interest rate should not significantly react to the union’s aggregate debt, whereas the reaction of fiscal instruments to inflation is also negligible. Instead, public consumption (tax rate) should react negatively (positively) to the level of public debt, while both instruments should react negatively to output gap. In small countries, fiscal policy debt feedback should be stronger than that for a big country under high-debt, but the reverse should occur in a low-debt scenario. Moreover, the reaction of a big (small) country’s fiscal policy to debt should weaken (increase) in high-debt scenarios. High-debt scenarios also optimally require higher (lower) government spending (taxes) feedback on output gap, particularly for small countries. Moreover, as cost-push shocks gain relative importance, country-specific fiscal instruments should react slightly and positively to output gap, whereas the tax rate (government spending) should be more (less) reactive towards debt. Under higher nominal rigidity, government expenditures (tax rate) should be slightly more (less) reactive towards output gap and debt. In turn, lower labor supply elasticity requires more union-wide inflation stabilization and a larger output stabilization burden on both country-specific fiscal instruments. Foreign-domestic goods complementarity relative to substitutability also requires larger reactions of fiscal instruments to output gap and larger debt stabilization from taxes.

Suggested Citation

  • Paulo Vieira & Celsa Machado & Ana Paula Ribeiro, 2016. "Optimal Fiscal Simple Rules for Small and Large Countries of a Monetary Union," EcoMod2016 9685, EcoMod.
  • Handle: RePEc:ekd:009007:9685
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    Keywords

    Monetary Union; Optimization models; Monetary issues;

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