Dynamic Fiscal Interactions and Economic Integration
27 Pages Posted: 29 Mar 2011
Date Written: November 15, 2010
Abstract
The paper investigates the fiscal policy interactions between economies sharing an integrated capital market and derives implications for the dynamics and sustainability of policy coordination. There are two main channels: (1) fiscal competition over mobile capital and (2) a public debt externality as the common market enables governments to spread the cost of national debt over the other countries. Coordinated fiscal policies, while increasing long run welfare, may not be adopted by democratically elected governments. A larger market can induce myopic governments to implement optimal policies when the union starts with relatively low levels of coordination. At high coordination levels, financial development or larger capital inflows can generate even closer coordination but also a rapid increase in public debt. The model's predictions are broadly consistent with the evolution of government finance aggregates along the process of economic integration in Europe.
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