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The optimal design of a fiscal union

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  • Dmitriev, Mikhail
  • Hoddenbagh, Jonathan

Abstract

We study the optimal design of a fiscal union within a currency union using an open economy model with nominal rigidities. We show that the optimal design of a fiscal union depends crucially on the degree of financial integration across countries as well as the elasticity of substitution between domestic and foreign goods. Empirical estimates of substitutability range between 1 and 12. If substitutability is low (around 1), risk-sharing occurs naturally via terms of trade movements even in financial autarky, country-level monopoly power is high and losses from terms of trade externalities dominate other distortions. On the other hand, if substitutability is high (greater than 1), risk-sharing does not occur naturally via terms of trade movements, country-level monopoly power is low and losses from nominal rigidities dominate other distortions. We show that members of a fiscal union should (1) coordinate labor and consumption taxes when substitutability is low to eliminate terms of trade distortions, and (2) coordinate contingent cross-country transfers when substitutability is high to improve risk-sharing, particularly when union members lose access to international financial markets. Contingent fiscal policy at the national level is also necessary to eliminate nominal rigidities in the presence of asymmetric shocks, and yields large welfare gains when goods are close substitutes.

Suggested Citation

  • Dmitriev, Mikhail & Hoddenbagh, Jonathan, 2012. "The optimal design of a fiscal union," MPRA Paper 46007, University Library of Munich, Germany, revised Apr 2013.
  • Handle: RePEc:pra:mprapa:46007
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    2. Cole, Alexandre Lucas & Guerello, Chiara & Traficante, Guido, 2020. "One Emu Fiscal Policy For The Euro," Macroeconomic Dynamics, Cambridge University Press, vol. 24(6), pages 1437-1477, September.
    3. Moyen, Stéphane & Stähler, Nikolai & Winkler, Fabian, 2019. "Optimal unemployment insurance and international risk sharing," European Economic Review, Elsevier, vol. 115(C), pages 144-171.
    4. Fabio Ghironi, 2018. "Macro needs micro," Oxford Review of Economic Policy, Oxford University Press, vol. 34(1-2), pages 195-218.
    5. Dmitriev, Mikhail & Hoddenbagh, Jonathan, 2012. "Price Stability In Small Open Economies," MPRA Paper 46118, University Library of Munich, Germany, revised Feb 2013.
    6. Dashkeev, Vladimir V & Turnovsky, Stephen J, 2018. "Balanced-budget rules and risk-sharing in a fiscal union," Journal of Macroeconomics, Elsevier, vol. 57(C), pages 277-298.

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    More about this item

    Keywords

    Fiscal Union; International Macroeconomics;

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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