Fiscal Policy and Currency Union. Sapienza

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1 Daniela Federici Enrico Saltari Sapienza Present and future of the EU and EMU: Debts, deficits, and related institutional designs December 2-3, 2016

2 Motivation The ongoing crisis in the eurozone underlines the weakness of a currency union that is not also a fiscal union. The traditional OCA theory has largely ignored the implications of monetary unification for fiscal policy making. It ignored the presence of significant cross-border spillovers of fiscal policy and how they may be strengthened within a monetary union In the presence of such spillovers, uncoordinated decisions made by governments may result in an ineffi cient outcome. A better outcome for all countries can occur if governments agree upon a coordinated policy, taking into account the interdependences between them. Much of the literature on international policy coordination stresses the possibility of negative transmission effects

3 Aim of the paper The channels of transmission, and whether the transmission is positive or negative, may depend on the type of exchange rate regime, the type of shock, the degree of capital mobility, etc. In the case of EMU the analysis of channels through which one country s fiscal choices affect the other members (and so of the possibility of negative spillovers) has to take into account that EMU is a system of mixed exchange rate It involves a fixed exchange rate among currency area s members and a flexible exchange rate towards the rest of the world. We build a model of a currency area comprising two small countries, whose common currency floats with respect to the rest of the world. We examine the consequences of a fiscal stance by one country for the EMU partner economy.

4 Aim of the paper Why is Germany s trade surplus so large? Two main reasons First, the German trade surplus is increased by tight fiscal policies squeezing the country s domestic spending, including spending on imports. Second, the euro is too weak (given German wages and production costs) to be consistent with balanced German trade. The comparatively weak euro is an underappreciated benefit to Germany of its participation in the currency union. This paper explores the consequences of monetary unification for the setting of fiscal policy. We focus on fiscal free riding in a union and the need for fiscal restrictions.

5 The Model We consider a world consisting of two countries with a permanently fixed exchange rate (normalized at unity) with a flexible exchange rate towards the rest of the world, considered as country 3. We assume that the two countries forming the currency area have no macroeconomic impact on the third country but are large enough to influence each other. The model equations are summarized as follows.

6 The Reduced-form Model S 1 (y 1 ) = I 1 (i 3 + r/r) + G 1 + B 12 (y 1, y 2, p 2 /p 1 ) + B 13 (y 1, y 3, r p 3 /p 1 ) S 2 (y 2 ) = I 2 (i 3 + r/r) + G 2 + B 21 (y 1, y 2, p 2 /p 1 ) + B 23 (y 2, y 3, r p 3 /p 2 ) M 1 + M 2 = p 1 L 1 (y 1, i 3 + r/r) + p 2 L 2 (y 2, i 3 + r/r) r F = B 13 (y 1, y 3, r p 3 /p 1 ) + B 23 (y 2, y 3, r p 3 /p 2 ) + ri 3 F

7 The Model The subscripts 1, 2, 3 indicate the two countries within the currency area and the rest of world respectively; S = private saving; y = real output; I =investment; i =nominal interest rate; B ij country i s net exports with respect to country j; p i = price of country s domestically produced good denominated in the currency area s currency; r = exchange rate defined as the amount of currency area money required to buy one unit of foreign exchange; M i = country i money supply; F is the total stock of net foreign assets held in the currency area. All expenditure variables are measured in real terms and in unit of the country s goods.

8 Prices Prices are variable according to a markup pricing over a nominal wage rate that react to changes in the consumer price index of the country. p i = (1 + g i )(L/y) i w i The nominal wage is affected by changes of the general price index w i = ω i (I i ). dw i /w i = ω i (di i /I ), 0 ω 1 where ω is a parameter measuring the degree of wage indexation and I i = α i1 p 1 + α i2 p 2 + α i3 r p 3, α i1 + α i2 + α i3 = 1 is a weighted average consumption bundle prices available in the union Hence price indexes are influenced by the area exchange rate vis-à-vis the rest of the world. If indexation is positive, the prices reaction to a variation of exchange rate is positive, p 1,r > 0 and p 2,r > 0.

9 Multipliers If exchange rate expectations are static, r=0. In the short run all the stocks are given. We consider only the first three equations of the model from which we obtain the short run endogenous variables y 1, y 2, r and then derive the comparative static effects on domestic and partner country incomes resulting undertaken by one of the countries. Solving the system, we get the relevant multipliers: y 1G1 = (S 2,y 2 + µ 2 )(L 1 p 1,r + L 2 p 2,r ) L 2 p 2,r [B 12,p (p 2,r p 1,r ) B 2 J y 2G1 = µ 12 (L 1p 1,r + L 2 p 2,r ) + L 1,y1 [B 12,p (p 2,r p 1,r ) B 23,r (1 p 2, J r G1 = µ 12 L 2,y 2 L 1,y1 (S 2,y2 + µ 2 ). J

10 Spillover effects with static expectations We assume that J > 0. We are interested in establishing whether fiscal policy undertaken by one currency area country have beggar-my-neighbour effects on the other area country. Thus we focus on the effects of G 1 on y 2, i.e. y 2G1. We analyze the two cases of static and rational expectations.

11 Main findings (static expectations) 1 Contractionary fiscal policy of country 1 (Germany) may produce a contractionary effect on country 2 (Italy) that is y 2G1 > 0. The relative degrees of indexation in the two countries are important in order to examine the domestic impact and the cross-country effect of fiscal policy in the union.

12 Main findings (static expectations) 1 Contractionary fiscal policy of country 1 (Germany) may produce a contractionary effect on country 2 (Italy) that is y 2G1 > 0. The relative degrees of indexation in the two countries are important in order to examine the domestic impact and the cross-country effect of fiscal policy in the union. 2 Since the first term in the numerator (µ 12 (L 1 p 1,r + L 2 p 2,r )) is positive, the sign of y 2G1 depends on the relative flexibility of the two countries area when the external exhange rate changes. If the country 2 prices are more flexible than country 1 (Italy), the contractionary fiscal policy may produce a reduction of country 2 income.

13 Main findings (static expectations) 1 Contractionary fiscal policy of country 1 (Germany) may produce a contractionary effect on country 2 (Italy) that is y 2G1 > 0. The relative degrees of indexation in the two countries are important in order to examine the domestic impact and the cross-country effect of fiscal policy in the union. 2 Since the first term in the numerator (µ 12 (L 1 p 1,r + L 2 p 2,r )) is positive, the sign of y 2G1 depends on the relative flexibility of the two countries area when the external exhange rate changes. If the country 2 prices are more flexible than country 1 (Italy), the contractionary fiscal policy may produce a reduction of country 2 income. 3 To sum up, the signs of y 1G1 and y 2G1 are indeterminate because of the presence of the terms p i,r

14 Rational Expectations In the case of rational expectations, r = r and so the model has to be examined from the dynamic point of view To examine the dynamics of the expectations-augmented model we solve the model for the two dynamic variables, r and F. Linearizing the model at the long run equilibrium where r and F = 0 we obtain r F = [ H11 0 H 21 H 22 ] r r F F

15 Rational Expectations We limit ourselves to an examination of the qualitative results indicating only the signs of the elements of the determinant. It can be shown that H 22 is always positive, while the signs of H 11 and H 21 are not unequivocal. The signs of H 11 will be negative in the cases of fix prices and of complete indexation. In the other cases it will also be negative under further plausible assumptions. Hence the pattern of signs in the coeffi cient matrix of the dynamic system is [ ] 0? + Since the determinant of the matrix is negative, the equilibrium point is certainly a saddle point.

16 Rational Expectations Given that F is predetermined at any given moment, the exchange rate is free to make discrete jump in response to unanticipated events or "news". Unanticipated current or future policy changes cause r to jump into the unique convergent solution path. The long run effect of an increase in public spending by one country within the union is for both r and F to fall. The impact effect of an unanticipated increase in G 1 is a jump appreciation of the exchange rate which overshoots its long run equilibrium.

17 Rational Expectations The currency union runs a current account deficit and after the initial shock, the external exchange rate depreciates smootly toward equilibrium along the stable arm and external net assets are decreasing. If prices are fixed, beggar-my-neighbour can occur as we saw in the case of static expectations. In the variable price case results are indeterminate. This indeterminacy is strengthened by any change in F that will affect the currency area s current account equilibrium. The current account not only provides a mechanism for the long run adjustment of the union s exchange rate, but also generates short run changes in the exchange rate as "news" about the future course of the current account affect expectations.

18 Conclusions The eurozone was supposed to be immune from exchange-rate risks and payment disequilibria. These expectations proved delusional because of the accumulation of large payment imbalances between its members, deriving from persistent underlying divergences in prices and costs. As shown above, countries are different in the way the demand for their exports is affected by changes in relative prices. German exports are less sensitive than other euro area countries, therefore better equipped to maintain their market shares as the currency appreciates. A real-effective appreciation of the euro has a more detrimental effect on Italy than Germany. This happened because monetary union did not eliminate market segmentation and nominal rigidities, while fiscal policies stayed national and continued to respond to national goals, with inadequate attention to the convergence requirements of monetary union.

19 Thanks for your attention!