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The optimal design of a fiscal union

Mikhail Dmitriev and Jonathan Hoddenbagh ()

MPRA Paper from University Library of Munich, Germany

Abstract: We study the optimal design of a fiscal union within a currency union using an open economy model with nominal rigidities. We show that the optimal design of a fiscal union depends crucially on the degree of financial integration across countries as well as the elasticity of substitution between domestic and foreign goods. Empirical estimates of substitutability range between 1 and 12. If substitutability is low (around 1), risk-sharing occurs naturally via terms of trade movements even in financial autarky, country-level monopoly power is high and losses from terms of trade externalities dominate other distortions. On the other hand, if substitutability is high (greater than 1), risk-sharing does not occur naturally via terms of trade movements, country-level monopoly power is low and losses from nominal rigidities dominate other distortions. We show that members of a fiscal union should (1) coordinate labor and consumption taxes when substitutability is low to eliminate terms of trade distortions, and (2) coordinate contingent cross-country transfers when substitutability is high to improve risk-sharing, particularly when union members lose access to international financial markets. Contingent fiscal policy at the national level is also necessary to eliminate nominal rigidities in the presence of asymmetric shocks, and yields large welfare gains when goods are close substitutes.

Keywords: Fiscal Union; International Macroeconomics (search for similar items in EconPapers)
JEL-codes: E5 E58 F41 (search for similar items in EconPapers)
Date: 2012-12, Revised 2013-04
New Economics Papers: this item is included in nep-mac and nep-opm
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https://mpra.ub.uni-muenchen.de/46007/1/MPRA_paper_46007.pdf original version (application/pdf)
https://mpra.ub.uni-muenchen.de/46166/1/MPRA_paper_46007.pdf revised version (application/pdf)

Related works:
Working Paper: The Optimal Design of a Fiscal Union (2013) Downloads
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