Smoothing Shocks and Balancing Budgets in a Currency Union

56 Pages Posted: 26 Jan 2012

See all articles by James S. Costain

James S. Costain

Banco de España - Research Department

Beatriz de Blas

Universidad Autónoma de Madrid

Date Written: January 25, 2012

Abstract

We study simple fiscal rules for stabilizing the government debt level in response to asymmetric demand shocks in a country that belongs to a currency union. We compare debt stabilization through tax rate adjustments with debt stabilization through expenditure changes. While rapid and flexible adjustment of public expenditure might seem institutionally or informationally infeasible, we discuss one concrete way in which this might be implemented: setting salaries of public employees, and social transfers, in an alternative unit of account, and delegating the valuation of this numeration to an independent fiscal authority. Using a sticky-price DSGE matching model of a small open economy in a currency union, we compare the business cycle implications of several different fiscal rules that all achieve the same reduction in the standard deviation of the public debt. In our simulations, compared with rules that adjust tax rates, a rule that stabilizes the budget by adjusting public salaries and transfers reduces fluctuations in consumption, employment, and private and public after-tax real wages, thus bringing the market economy closer to the social planner’s solution.

Keywords: Fiscal authority, public wages, sovereign debt, monetary union

JEL Classification: E24, E32, E62, F41

Suggested Citation

Costain, James S. and de Blas, Beatriz, Smoothing Shocks and Balancing Budgets in a Currency Union (January 25, 2012). Banco de Espana Working Paper No. 1207, Available at SSRN: https://ssrn.com/abstract=1991755 or http://dx.doi.org/10.2139/ssrn.1991755

James S. Costain (Contact Author)

Banco de España - Research Department ( email )

Alcala 50
28014 Madrid
Spain

Beatriz de Blas

Universidad Autónoma de Madrid ( email )

Campus Cantoblanco
C/Kelsen, 1
Madrid, Madrid 28049
Spain

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