Labor mobility and fiscal policy in a currency union

Labor mobility is commonly taken as a property of an optimal currency area. But how does that property affect the outcome of fiscal policies? We address this issue with a two country - two period model, where both asymmetric and symmetric productivity shocks may hit the countries. We show that perfect (costless) labour mobility is not necessarily welfare improving, since it prevents the national fiscal authorities from pursuing independent policies, opening the way to a coordination problem between them, which is particularly relevant when the two countries differ for their intertemporal preferences. With symmetric shocks, the federal fiscal policy can improve welfare over national policies by playing a coordinating role. With asymmetric shocks, the federal fiscal policy allows both countries to reach a higher productive efficiency; to do that, the federal government must be endowed with a federal budget, playing a stronger role than plain coordination between countries.