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Absorbing Shocks: National Rainy-Day Funds and Cross-Country Transfers in a Fiscal Union

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Abstract

In this paper we investigate the interplay between national rainy-day funds and supra-national transfers in a fiscal union. Given that the EU has established rules limiting deficits, national rainy-day funds could in theory provide a way for countries to obey the rules and use fiscal policy, yet avoid using austerity measures during a recession. The rainy-day fund is self-insurance and we examine the funding of a national rainy-day fund for a country in isolation. We then introduce a fiscal union while allowing member countries to retain some fiscal policy control. We find that moral hazard leads to lower contributions to a rainy day fund with a fiscal union present, and further that the higher the fiscal transfer, the lower will be the contributions to the rainy-day fund. The optimal size of the fiscal union trades-off the ex-post insurance provided by the union and the moral hazard which reduces national ex-ante preparation for stabilization policies. Optimally, the insurance provided by the fiscal union should be lower (1) the more effective is own-fiscal policy; (2) the more the presence of the fiscal union reduces rainy-day fund savings; (3) the lower is the relative probability of recession; and (4) the lower is the utility gain of redistribution in the union. We also find that commitment to a transfer policy is essential. A fiscal union that is prone to break the rules on transfers negatively impacts the ex-ante contributions to individual members’ rainy day funds.

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  • Timothy J. Goodspeed, 2016. "Absorbing Shocks: National Rainy-Day Funds and Cross-Country Transfers in a Fiscal Union," Economics Working Paper Archive at Hunter College 446, Hunter College Department of Economics, revised 07 Nov 2016.
  • Handle: RePEc:htr:hcecon:446
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    More about this item

    Keywords

    fiscal union; fiscal transfers; federation; rainy-day funds; fiscal stabilization;
    All these keywords.

    JEL classification:

    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • H1 - Public Economics - - Structure and Scope of Government
    • H6 - Public Economics - - National Budget, Deficit, and Debt
    • H7 - Public Economics - - State and Local Government; Intergovernmental Relations

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