Macroeconomic adjustment in the euro area: The role of fiscal policy

Abstract

We asses the extent to which fiscal policy, as automatic stabilisers, can stabilise national economies within EMU. We use a two-country New Keynesian DGE model with liquidity constrained consumers, sticky prices, and a home bias in the composition of national consumption bundles. The model allows a variety of channels for fiscal policy, and is estimated using Euro area data. We analyse the the interaction of monetary and fiscal policies in EMU and demonstrate that, perhaps surprisingly, macroeconomic adjustment is not always facilitated by fiscal stabilisers in the case of certain types of shocks. The stabilising effects of fiscal policy at the national level are strictly dependent on the existence of home bias in consumption. JEL Codes: E58, E62, E63