On the (In)Effectiveness of Fiscal Devaluations in a Monetary Union

Abstract

This paper explores the fiscal devaluation hypothesis in a model of a monetary union characterised by national fiscal policies and supranational monetary policy. We show that a unilateral tax shift towards indirect taxes in one of the countries produces small but non-negligible long run effects on output and consumption within and between the two countries only when international financial markets are perfectly integrated. In contrast to the existing literature, we find that short-run effects are not always amplified by nominal wage rigidities. We document also how short-run effects of the tax shift depend on the choice of the inflation index stabilized by the central bank and on whether the tax shift is anticipated.

Keywords: fiscal regimes, monetary policy, currency union

JEL Classification: E61, E63, F42