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Federal Reserve Bank of Minneapolis
Staff Report
Fiscal Unions Redux
Patrick J. Kehoe
Elena Pastorino
Abstract

Before the advent of sophisticated international financial markets, a widely accepted belief was that within a monetary union, a union-wide authority orchestrating fiscal transfers between countries is necessary to provide adequate insurance against country-specific economic fluctuations. A natural question is then: Do sophisticated international financial markets obviate the need for such an active union-wide authority? 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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Patrick J. Kehoe & Elena Pastorino, Fiscal Unions Redux, Federal Reserve Bank of Minneapolis, Staff Report 543, 21 Feb 2017.
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Keywords: Cross-country externalities; Cross-country insurance; Cross-country transfers; Fiscal externalities; International financial markets; International transfers; Optimal currency area
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