NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Financial Markets and Fiscal Unions

Patrick J. Kehoe, Elena Pastorino

NBER Working Paper No. 23235
Issued in March 2017
NBER Program(s):Economic Fluctuations and Growth, International Finance and Macroeconomics, International Trade and Investment, Monetary Economics, Public Economics

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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