NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Financial Markets and Fiscal Unions

Patrick J. Kehoe, Elena Pastorino

NBER Working Paper No. 23235
Issued in March 2017
NBER Program(s):EFG, IFM, ITI, ME, PE

Do sophisticated international financial markets obviate the need for an active union-wide authority to orchestrate fiscal transfers between countries to provide adequate insurance against country-specific economic fluctuations? We argue that they do. Specifically, we show that in a benchmark economy with no international financial markets, an activist union-wide authority is necessary to achieve desirable outcomes. With sophisticated financial markets, however, such an authority is unnecessary if its only goal is to provide cross-country insurance. Since restricting the set of policy instruments available to member countries does not create a fiscal externality across them, this result holds in a wide variety of settings. Finally, we establish that an activist union-wide authority concerned just with providing insurance across member countries is optimal only when individual countries are either unable or unwilling to pursue desirable policies.

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Document Object Identifier (DOI): 10.3386/w23235

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