Fiscal Policy Coordination in a Monetary Union at the Zero-Lower-Bound

Following the Great Recession, Eurozone governments faced adverse economic environments: high public debt to GDP ratios, depressed outputs and the prospect of monetary policy hitting the zero-lower-bound (ZLB). The goal of this paper is to assess how stronger cross-region fiscal policy spillovers arising from constrained monetary policy may lead to different strategic interactions. This paper also offers a detailed analysis of the fiscal policy trade-offs the Eurozone faced when monetary policy became constrained.

Using the Mélèze fiscal DSGE model developed at the Insee and estimating structural shocks to replicate the conditions where, absent any additional shock, the Eurozone economy would have been stuck at the ZLB for three years starting in 2013, we show that cross-border spillovers from fiscal policy are substantially higher without monetary offset. Increasing with the size of fiscal consolidation measures, they can amount up to a sixth of the domestic impact in the case of spending-based consolidations, and to almost half of the domestic impact in the case of VAT-based consolidations.

Outside the ZLB, there are gains from fiscal coordination across countries as expansion in one region benefits less to the whole union than for the region undergoing expansion due to the reaction of monetary policy. As such, cooperation tends to limit fiscal expansion, even in a static setting that does not take into account issues of rule credibility nor time inconsistency. At the ZLB however, monetary policy being constrained, national objectives tend to be closer and the coordinated policy is less consolidating. Moreover, cooperation encourages symmetric rather than asymmetric policies.