A fiscal capacity with endogenous access in a monetary union

Abstract

We study the stabilization properties and welfare implications of a fiscal capacity in a New Keynesian model for a monetary union. A novel feature of the model is that access to the fiscal capacity is conditional on a country’s public debt accumulation being sufficiently low. Likewise, the national fiscal effort to stabilize debt is more ambitious at higher debt levels. We show that the fiscal capacity reduces union-wide macroeconomic variability and raises union-wide welfare by reducing the incidence of regimes with large (pro-cyclical) fiscal consolidations. Welfare gains are higher under greater trade openness and price stickiness. • The macroeconomic stabilization properties and welfare implications of a central fiscal capacity in a monetary union is studied using a two-country New Keynesian model. • Access to the fiscal capacity is endogenously determined by member states’ public finances: only if the change in the debt-to-GDP ratio is sufficiently low is access granted. • Debt stabilization efforts by the government also depend on public finances: if the debt-toGDP ratio exceeds a certain threshold, debt stabilization efforts are intensified. • The fiscal capacity can enhance welfare for both member states of the monetary union. By relaxing the government budget constraint, the fiscal capacity prevents a sharp pro-cyclical fiscal tightening during recessions that would otherwise worsen economic conditions. • Greater trade openness and price stickiness increase the welfare gains from the fiscal capacity.