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

Annika Ivens

Journal of International Money and Finance, 2018, vol. 87, issue C, 62-81

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.

Keywords: Fiscal devaluation; Value added tax; 2-country model; Non-tradables (search for similar items in EconPapers)
JEL-codes: E69 F41 F45 H29 (search for similar items in EconPapers)
Date: 2018
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Handle: RePEc:eee:jimfin:v:87:y:2018:i:c:p:62-81