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On Public Spending and Economic Unions

Author

Listed:
  • Fernando Broner
  • Alberto Martin
  • Jaume Ventura
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 union's 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.

Suggested Citation

  • Fernando Broner & Alberto Martin & Jaume Ventura, 2020. "On Public Spending and Economic Unions," NBER Working Papers 27831, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:27831
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F45 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Macroeconomic Issues of Monetary Unions

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