Fiscal Policy as a Stabilisation Device for an Open Economy Inside or Outside EMU
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.
|Date of creation:||Nov 2005|
|Date of revision:|
|Contact details of provider:|| Postal: Department of Economics, University of St. Andrews, Fife KY16 9AL|
Phone: 01334 462420
Fax: 01334 462444
Web page: http://www.st-andrews.ac.uk/cdma
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Campbell Leith & Simon Wren-lewis, 2006.
"Fiscal Sustainability in a New Keynesian Model,"
WEF Working Papers
0006, ESRC World Economy and Finance Research Programme, Birkbeck, University of London.
- Simon Wren-Lewis & Campbell Leith, 2007. "Fiscal Sustainability in a New Keynesian Model," Economics Series Working Papers 310, University of Oxford, Department of Economics.
- Campbell Leith & Simon Wren-Lewis, 2006. "Fiscal Sustainability in a New Keynesian Model," Working Papers 2006_11, Business School - Economics, University of Glasgow, revised Nov 2008.
- Leith, Campbell & Wren-Lewis, Simon, 2012. "Fiscal Sustainability in a New Keynesian Model," SIRE Discussion Papers 2012-84, Scottish Institute for Research in Economics (SIRE).
- Pierpaolo Benigno & Michael Woodford, 2004.
"Optimal Monetary and Fiscal Policy: A Linear-Quadratic Approach,"
in: NBER Macroeconomics Annual 2003, Volume 18, pages 271-364
National Bureau of Economic Research, Inc.
- Pierpaolo Benigno & Michael Woodford, 2003. "Optimal monetary and fiscal policy: a linear-quadratic approach," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
- Pierpaolo Benigno & Michael Woodford, 2003. "Optimal Monetary and Fiscal Policy: A Linear Quadratic Approach," NBER Working Papers 9905, National Bureau of Economic Research, Inc.
- Benigno, Pierpaolo & Woodford, Michael, 2004. "Optimal monetary and fiscal policy: a linear-quadratic approach," Working Paper Series 0345, European Central Bank.
- Pierpaolo Benigno & Michael Woodford, 2004. "Optimal monetary and fiscal policy: a linear-quadratic approach," International Finance Discussion Papers 806, Board of Governors of the Federal Reserve System (U.S.).
- Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999.
"The Science of Monetary Policy: A New Keynesian Perspective,"
CEPR Discussion Papers
2139, C.E.P.R. Discussion Papers.
- Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
- 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.
- Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," NBER Working Papers 7147, National Bureau of Economic Research, Inc.
- Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
When requesting a correction, please mention this item's handle: RePEc:san:cdmacp:0506. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (the School of Economics)
If references are entirely missing, you can add them using this form.