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Optimal Fiscal Substitutes for the Exchange Rate in a Monetary Union

Christoph Kaufmann

No 86, Working Paper Series in Economics from University of Cologne, Department of Economics

Abstract: This paper studies Ramsey-optimal monetary and fiscal policy in a New Keynesian 2-country open economy framework, which is used to assess how far fiscal policy can substitute for the role of nominal exchange rates within a monetary union. Giving up exchange rate exibility leads to welfare costs that depend significantly on whether the law of one price holds internationally or whether firms can engage in pricing-to-market. Calibrated to the euro area, the welfare costs can be reduced by 86% in the former and by 69% in the latter case by using only one tax instrument per country. Fiscal devaluations can be observed as an optimal policy in a monetary union: if a nominal devaluation of the domestic currency were optimal under exible exchange rates, optimal fiscal policy in a monetary union is an increase of the domestic relative to the foreign value added tax.

Keywords: Monetary union; Optimal monetary and fiscal policy; Exchange rate (search for similar items in EconPapers)
JEL-codes: E63 F41 F45 (search for similar items in EconPapers)
Date: 2016-09-21
New Economics Papers: this item is included in nep-dge, nep-eec, nep-mac, nep-mon and nep-opm
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Journal Article: Optimal fiscal substitutes for the exchange rate in monetary unions (2019) Downloads
Working Paper: Optimal fiscal substitutes for the exchange rate in a monetary union (2016) Downloads
Working Paper: Optimal Fiscal Substitutes For The Exchange Rate In A Monetary Union (2016) Downloads
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