Abstract
We derive the optimal fiscal transfer scheme for countries in a monetary union to offset the welfare losses resulting from asymmetric shocks and nominal rigidities. Optimal transfers involve a tradeoff between reducing national output gaps and the provision of consumption insurance across countries, where the weight of the former increases relative to the latter as consumption home bias rises. The welfare gains from optimal transfers increase in wage rigidity and trade elasticities and are particularly large when risk-sharing through financial markets breaks down. For the average euro area economy, the welfare gains from optimal transfers range from 0.50% of permanent consumption under complete markets and low wage rigidity to 6.09% of permanent consumption under financial autarky and high wage rigidity.
Highlights
In a monetary union that faces nominal rigidities, asymmetric shocks across union members cannot be offset by the common central bank
We derive the optimal fiscal transfer scheme for countries in a monetary union to off-set the welfare losses resulting from asymmetric shocks and nominal rigidities
Optimal transfers involve a trade-off between reducing national output gaps and the provision of consumption insurance across countries, where the weight of the former increases relative to the latter as consumption home bias rises
Summary
In a monetary union that faces nominal rigidities, asymmetric shocks across union members cannot be offset by the common central bank. This has important implications for welfare, as higher export substitutability (higher trade elasticity) increases the consumption and labor wedges, which raises the cost of business cycle fluctuations in a monetary union, and strengthens the need for a fiscal union to offset the negative impacts of asymmetric shocks across countries. To quantify the potential welfare gains from a fiscal union, we calibrate consumption home bias and trade elasticities to recent empirical estimates for euro area countries in an extended version of the model that includes imperfect cross-country risk-sharing, asymmetric shocks and Calvo wage rigidity.. Of various forms of fiscal federalism in a monetary union and, consistent with our findings, shows that relative to the decentralized allocation with incomplete financial markets, a centralized transfer union decreases the volatility of consumption, labor and output amongst member economies, yielding positive welfare gains
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