Fiscal devaluation and labor market frictions in a monetary union

Abstract

We evaluate the macroeconomic and labor market impact of a fiscal devaluation in one region of a monetary union. We simulate a monetary-union model of the euro area (EA) and the world economy featuring search-and-matching labor markets. We obtain the following results. First, a region-specific devaluation improves trade-competitiveness, macroeconomic conditions, and employment. Second, a permanent regional fiscal devaluation has more expansionary labor-intensive effects than lowering the capital income tax rate and increasing the consumption tax rate. Third, simultaneous EA-wide and world-wide fiscal devaluations have expansionary effects on macroeconomic and labor market conditions. Fourth, a EA accommodative monetary policy enhances the expansionary effects of the EA-wide fiscal devaluation on the generic Member State; to the opposite, the Member State faces lower economic activity and employment if the world-wide fiscal devaluation is accompanied by an accommodative monetary stance outside the EA.