DP3580 International Interdependencies in Fiscal Stabilization Policies
Trade links imply that business cycle fluctuations are transmitted to trade partners. To the extent that fiscal policy can mitigate business cycle fluctuations this implies that there are international interdependencies in stabilization policies. We analyse the role of fiscal policy in mitigating risk or providing implicit insurance in the presence of capital market imperfections, and how this is affected by adjustment failures (rigid wages). It is shown that there is a welfare case for an active stabilization policy and that it is larger in the presence of adjustment failures (rigid wages). The international interdependency may in the absence of adjustment failures imply that non-cooperative stabilization policies entail excessive stabilization, whereas there is always insufficient stabilization in the presence of adjustment failures.
