Horizontal Transfers and Consumption Smoothing in a Monetary Union

Abstract The paper investigates the impact of automatic horizontal fiscal transfers on risk sharing and consumption smoothing in a 2-country DSGE model of monetary union. In particular, it uses the Asdrubali et al. (1996) approach to quantify and decompose the strength of consumption smoothing. The system of horizontal transfers between member countries has no borrowing capacity and, hence, needs to be balanced in every period in time. The transfers increase the fiscal space of national governments in (relatively) adverse situations, i. e. when the budget balance deteriorates (falling tax revenue, higher expenditure) and debt issuance is costly or constrained. The simulation results illustrate the smoothing capacity of horizontal transfers, but also suggest a significant degree of crowding-out of alternative risk sharing channels. Consequently, net stabilisation gains in the “normal times” scenario are small. Net gains increase when financial constraints in the recipient country tighten at the national level.