The performance of simple fiscal policy rules in monetary union

The paper analyses the stabilising potential of simple fiscal policy rules for a small open economy in monetary union in a 2-region DSGE model with nominal and real rigidities. We consider simple fiscal instrument rules for government purchases, transfers, and consumption, labour and capital taxes in analogy to interest rate rules in monetary policy. The paper finds a dichotomy in the welfare effects of fiscal policy for liquidity-constrained and intertemporal optimising households, i.e. policies enhancing the welfare of one group tend to reduce the welfare of the other one. Moderate average welfare gains from optimal policy contrast with large losses from non-optimal policy. Fiscal rules that respond to employment fluctuations may be preferred to rules responding to indicators of price competitiveness, because optimal policy in the former corresponds more closely to the idea of countercyclical stabilisation. The paper also emphasises the strong impact of the budgetary closure rule on the welfare effects of business cycle stabilisation.

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