Abstract
Does monetary policy play a role in fiscal federalism? This paper presents a novel implication of monetary policy shocks by studying their heterogeneous effects across federal-states and their consequent connection to fiscal equalization. A two-region monetary union DSGE model with a federal equalization mechanism shows that capital intensive states experience a relatively larger contraction following a positive monetary policy shock, due to the greater share that capital takes in their production process. This, in turn, brings them greater inflows of federal grants. We show that state-heterogeneity in capital intensity is explained by levels of natural resource abundance over large periods, and hence by pre-determined geographical characteristics. Based on this identification strategy, we test the model's predictions using a panel of U.S. states over the period 1969-2007 and find that following a one standard deviation monetary policy shock, output growth (output share of federal transfers) in capital intensive states contemporaneously decreases (increases) by 1% relative to their counterparts, on average. In addition, we find no differential effects on other state-level economic indicators, consistent with the model.
Published Version
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