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On The Need For Fiscal Discipline in an Union

  • Joshua Aizenman

This paper investigates the behavior of public debt in countries forming a union (as outlined, e.g., by the Maastricht treaty). We consider a federal union of states where the center has limited control over the spending patterns of the union members, and where the union members' behavior has repercussions for the future public debt. The public has preferences against higher public debt, and will oust high-debt administrations. Adverse shocks are shown to induce a regime switch from a cooperative outcome to limited cooperation, and from limited cooperation to the noncooperative outcome. While a transitory adverse shock calls for a higher public debt in the cooperative regime, the switch towards limited cooperation entails a drop in the public debt (relative to the cooperative desirable outcome). With limited cooperation further drops in income will call for a drop in public debt. If the adverse shock is powerful enough, sustaining limited cooperation may become unfeasible. A regime switch may yield nonlinearities, where the macroeconomic behavior is abruptly altered following the switch. Our model provides a tentative support for limits on public debt, needed to free the instrument of deficit financing for use in bad recessions.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4656.

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Date of creation: Feb 1994
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Publication status: published as "Fiscal discipline in a union," in The Political Economy of Economic Reforms, ed by F. Sturzenegger and M. Tommasi, MIT Press, 1998,pp. 185-208.
Handle: RePEc:nbr:nberwo:4656
Note: IFM
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  1. Willem H. Buiter & Richard C. Marston, 1985. "International Economic Policy Coordination," NBER Books, National Bureau of Economic Research, Inc, number buit85-1, October.
  2. Alesina, A. & Drazen, A., 1991. "Why Are Stabilizations Delayed?," Papers 6-91, Tel Aviv - the Sackler Institute of Economic Studies.
  3. Alessandra Casella, 1990. "Participation in a Currency Union," NBER Working Papers 3220, National Bureau of Economic Research, Inc.
  4. Alex Cukierman, 1992. "Central Bank Strategy, Credibility, and Independence: Theory and Evidence," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262031981, June.
  5. Canzoneri, Matthew B., 1989. "Adverse incentives in the taxation of foreigners," Journal of International Economics, Elsevier, vol. 27(3-4), pages 283-297, November.
  6. Wyplosz, Charles, 1991. "Monetary Union and Fiscal Policy Discipline," CEPR Discussion Papers 488, C.E.P.R. Discussion Papers.
  7. Aizenman, Joshua, 1992. "Competitive Externalities and the Optimal Seigniorage," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 24(1), pages 61-71, February.
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