Effects of Cross Country Fiscal Interdependence on Multipliers within a Monetary Union

This paper analyzes the effect of time-varying cross-country fiscal policy interaction on output and consumption multipliers in a monetary union. The framework is that of a standard New Keynesian two-country model with distortionary taxes and Markov Switching fiscal regimes. The paper uses a two-state Markov switching process for each country. In one state, taxes respond greater to changes in fiscal spending and show larger consolidation efforts, which is described by the term passive. In the other regime, described as active, no debt reduction exists and the spending is mostly deficit-financed. Since this analysis is based on the Euro Area, I abstract from fiscal monetary interaction and focus on member and union fiscal interdependence, including monetary imperfections and trade effects. Furthermore, the paper differentiates between national and union aggregate government spending shocks. The results indicate that small countries benefit from a centralized monetary authority through decreases in real interest rates. Moreover, trade intensity increases the returns from union-wide solutions. In regards to the fiscal regime policy effects, a combination of active/passive leads to the highest output multiplier since it minimizes the negative wealth effect and the terms of trade loss. However, consumption benefits from national solutions to keep overall inflation low. These opposing effects increase with the level of trade dependence and size of a member