A Fiscal Capacity with Endogenous Access in a Monetary Union

Abstract

We study the stabilization properties and welfare implications of a fiscal capacity in a New Keynesian model for a monetary union. A novel feature of the model is that access to the fiscal capacity is conditional on a country’s public debt accumulation being sufficiently low. Likewise, the national fiscal effort to stabilize debt is more ambitious at higher debt levels. We show that the fiscal capacity reduces union-wide macroeconomic variability and raises union-wide welfare by reducing the incidence of regimes with large (pro-cyclical) fiscal consolidations. Welfare gains are higher under greater trade openness and price stickiness.

Keywords: fiscal capacity, monetary union, endogenous regime switching