Fiscal transfers in a two-level fiscal framework: stabilizing properties according to the fiscal instrument

In a two-country Dynamic and Stochastic General Equilibrium (DSGE) model, I document the stabilizing properties of fiscal transfers between currency union members according to the nature of public spending allowed by these transfers for the recipient economy. To do this, I model a two-level fiscal framework for the monetray union in which the central autority collects one share of national fiscal revenues and determine how these revenues are redistributed among countries following a simple fiscal transfer rule. We assume that the central autority is allowed to decide how the recipient economy use these funds. The main result of this paper is that the stabilizing properties of fiscal transfer schemes strongly depend on the way the recipient economy uses the funds following the fiscal transfer. Public consumption, transfers and VAT are more effective to stabilize macroeconomic differentials between both economies of the currency union when asymmetric demand shocks occur while the labor income tax and the social protection tax are more effective in the case of an asymmetric productivity shock.