Fiscal devaluation in the Euro area: The role of rigidities, non-tradables, and social security contributions

Abstract

This paper explores the trade-balance effects of a unilateral fiscal devaluation in a monetary union model with two symmetric countries where the law of one price holds. The paper differs from existing studies in three ways: First, I explore a decrease in the employees’ share of social security contributions (SSC) and show that the view of assuming a decreases in the employers’ share to be more effective does not hold to be true. Second, I explicitly explore the role of nominal rigidities and show that a devaluation implemented in a simple model with flexible prices and wages has noticeable real effects. Moreover, the results indicate that inducing nominal rigidities in fact limits the effectiveness of a fiscal devaluation in raising the trade balance if conducted as a decrease in the employees’ share of SSC. And third, I allow for a different taxation of tradable and non-tradable goods and show that increasing value added taxes (VAT) in a way which affects tradables more than non-tradables is a more effective measure – a result which is at odds with propositions frequently found in literature to abolish reduced rates of VAT. I use these insights to simulate a fiscal devaluation implemented in Euro area countries featuring trade balance deficits in 2015 by using a more elaborate New-Keynesian 2-country model and find that the effectiveness of a fiscal devaluation crucially depends on the fiscal instruments used.