Working Paper: CEPR ID: DP15309
Authors: Jaume Ventura; Fernando Broner; Alberto Martin
Abstract: We analyze the conduct of fiscal policy in a financially integrated union in the presence of financial frictions. Frictions create a wedge between the return to investment and the union interest rate. This leads to an over-spending externality. While the social cost of spending is the return to investment, governments care mostly about the (depressed) interest rate they face. In other words, the crowding out effects of public spending are partly "exported" to the rest of the union. We argue that it may be hard for the union to deal with this externality through the design of fiscal rules, which are bound to be shaped by the preferences of the median country and not by efficiency considerations.We also analyze how this overspending externality - and the unionís ability to deal with it effectively - changes when the union is financially integrated with the rest of the world. Finally, we extend our model by introducing a zero lower bound on interest rates and show that, if financial frictions are severe enough, the union is pushed into a liquidity trap and the direction of the spending externality is reversed. At such times, fiscal rules that are appropriate during normal times might backfire.
Keywords: public spending; economic union; crowding out; financial frictions; spending externalities; fiscal coordination
JEL Codes: E62; F32; F34; F36; F41; F42; F45
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial frictions (G19) | overspending externality (D62) |
| overspending externality (D62) | public spending (H59) |
| public spending (H59) | investment returns (G11) |
| financial integration with the rest of the world (F30) | overspending externality (D62) |
| severe financial frictions (E44) | liquidity trap (E41) |
| liquidity trap (E41) | underspending externality (D62) |