Citation

Discussion Paper Details

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Title: On Public Spending and Economic Unions

Author(s): Fernando A Broner, Alberto Mart�n and Jaume Ventura

Publication Date: September 2020

Keyword(s): Crowding out, Economic union, Financial Frictions, Fiscal coordination, Public Spending and Spending externalities

Programme Area(s): Financial Economics, International Macroeconomics and Finance, International Trade and Regional Economics, Macroeconomics and Growth, Monetary Economics and Fluctuations and Public Economics

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.

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Bibliographic Reference

Broner, F, Mart�n, A and Ventura, J. 2020. 'On Public Spending and Economic Unions'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=15309