Country Size Matters: Fiscal Policy in Times of Crisis and Spillovers in the EMU

with Olfa Alouini

Chapter of Olfa Alouini’s PhD dissertation

Using a two-country micro-founded model of a monetary union with debt (detailed in the previous chapter) and allowing for cross-country heterogeneities in terms of size, openness and nominal rigidities, we simulate an increase in government spending as well as tax cuts in response to a crisis and comparatively assess their effectiveness. We find that increasing government spending is more effective in spurring output compared to tax cuts on consumption or on the payroll. We also detail the cross-border spillovers in a monetary union of these policies and explain how they depend on asymmetries between countries. We find that countries always benefit from their partner’s fiscal stimuli (increase in public spending or tax cuts), especially small open ones. We put forward a strategic asymmetry: the home (or policy-making) country benefits more from an increase in public spending in terms of output and consumption, but its partner benefits from larger positive spillover effects in the case of tax cuts. Finally, we determine that in a monetary union “internal devaluation” is a less expansionary supply-side policy response to a crisis than increased public spending and it bears externalities on foreign public debt (+0.5% of induced debt than for other measures on average).

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