Debt, Deficits and Transition to EMU: A Small Country Analysis

Svend Erik Hougaard Jensen and Lars Grue Jensen

No 93-03, EPRU Working Paper Series from Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics

Abstract: This paper studies some macroeconomic effects in a small open economy of the fiscal policy rules implied by the Maastricht convergence criteria. The focus is upon the adjustment process in the run-up to EMU. Two country-specific shocks leading to higher public debts are considered: a fall in the tax revenue (relevant to an early pre-EMU stage) and a fall in aggregate demand (relevant to all stages of EMU). The results are found to depend crucially on the speed of adjustment of government expenditures and the priority given to debt reduction. In general we find that rules for fiscal descipline perform well if tax shochs are predominant. In case of demand shocks, however, fiscal rules are unwarranted.

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