 Stabilization Constraints from different-average Public Debt Levels in a Monetary Union with Country-size AsymmetryCelsa Machado and Ana Ribeiro No 3152, EcoMod2011 from EcoMod Abstract: In the sequence of the recent financial and economic crisis, the level of government indebtedness has increased considerably in many European and Monetary Union (EMU) countries. Besides i) undermine the sustainability of public finances and ii) amplify steady-state distortions relative to the efficient outcome, high public debt levels iii) directly hamper business cycle stabilization while creating incentives to bias monetary policy towards debt-stabilization concerns. Naturally, the latter risk is expected to be more effective under sufficiently large debt-to-output ratios. However, debt consequences on stabilization costs are not clearly unambiguous. Rising high public debt levels, by assigning a growing role for a central ban towards debt stabilization, may enlarge the scope of fiscal policy to stabilize the business cycle. In turn, the rise of the public debt levels, when they are small enough and monetary policy is still assigned to its traditional price stabilization task, may cause higher stabilization costs as it may force fiscal policy to accrued debt stabilization efforts. Moreover, the study of the stabilization consequences of higher government indebtedness is particularly relevant in a monetary union where national fiscal policymakers of different-size countries interact strategically with a single monetary authority. This paper analyses how the average level of public debt in a monetary union shapes optimal discretionary fiscal and monetary stabilization policies and affects the welfare of each country-member. We use a two-country micro-founded New-Keynesian macroeconomic model with monopolistic competition and sticky prices. The model allows for fiscal policy to have demand and supply-side effects, by considering as fiscal policy instruments the home-biased public consumption and the tax rate, under different union-average debt-constrained scenarios. We assume that the monetary authority - maximizing the union-wide welfare - and the fiscal authorities - maximizing their national counterparts - engage in discretionary policy games. Optimal solutions are computed numerically using appropriate algorithms to mimic cooperative outcomes and also to reflect the different timing structures of the (non-cooperative) policy games: Nash, monetary leadership and fiscal leadership.Preliminary numerical results indicate that, under policy cooperation, when large (small) steady-state debt-to-output ratios increase symmetrically in both countries, welfare improves (deteriorates) for the whole union and for the large country while deteriorating (improving) for the small country. This follows from the differences on how the stabilization performance of domestic and foreign shocks evolves with debt, under large and small-debt scenarios. The different monetary policy response under different debt-level scenarios determines that the stabilization performance of domestic shocks improves (deteriorates) while that of foreign shocks deteriorates (improves), when large (small) debt-to-output ratios increase. In turn, under non-cooperation (Nash, monetary leadership or fiscal leadership) only the large country is able to benefit from (symmetrically) higher levels of government indebtedness. The small country and the union as a whole face higher welfare stabilization costs, the higher debt-to-output levels are. Keywords: Monetary Union; Monetary issues; Optimization models (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:ekd:002625:3152 Access Statistics for this paper More papers in EcoMod2011 from EcoMod Contact information at EDIRC. |
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