Fiscal Stabilization in the EMU

We explore the welfare implications of several …scal policies in an estimated two-country New Open Economy Macroeconomics (NOEM) model of the European Monetary Union (EMU). The model features incomplete …nancial markets, home bias in …nal consumption baskets and in input utilization. We …rstly de…ne the optimal policy. In addition to the optimal provision of public goods, the optimal policy involves active …scal policies, stabilizing the …nal terms of trade. Since this optimal solution can not be decentralized, we also inspect the welfare implications of simple public spending rules. We …nd that (i) welfare maximizing public spending rules imply important welfare losses with respect to the optimal policy and (ii) estimated public spending rules imply low welfare losses with respect to welfare maximizing rules. As a consequence, the room for welfare improving changes in the design of …scal policies in the EMU is potentially low, as well as gains traditionally awaited from a potential reform of the Stability and Growth Pact.