Fiscal Policy in an Estimated Model of the European Monetary Union

We explore the welfare implications of several fiscal policies in an estimated two-country New Open Economy Macroeconomics (NOEM) model of the EuropeanMonetary Union (EMU). The model features incomplete financial markets and home bias in final consumption baskets. We define the optimal monetary and fiscal policy and contrast the (small) contribution of financial markets incompleteness to welfare losses. We also investigate the welfare implications of simple public spending rules. We find (i) that welfare maximizing public spending rules imply significant welfare losses with respect to the optimal policy - equivalent to an average 7.3% drop in permanent consumption and (ii) that estimated public spending rules imply low welfare losses with respect to welfare maximizing rules - equivalent to an average 1% drop in permanent consumption. In our framework, these losses can be reduced by either promoting a deeper trade integration in the EMU, or by increasing the number of available fiscal instruments.