Fiscal Policy in an Estimated Open-economy Model for the Euro Area

Abstract

This paper uses an estimated DSGE model for the euro area to study the effects of fiscal\nstabilisation policies. There are at least two features of the euro area economy which makes this\nanalysis interesting. First, there are nominal rigidities in goods and labour markets, and there are\nfinancial market frictions with a significant share of liquidity constrained households. Second, the\ngovernment is a major sector of the euro area economy. In this paper we look at fiscal\nstabilisation via government consumption, investment, transfers and wage taxes. We find\nempirical evidence for systematic countercyclical fiscal policy. Consistent with previous\nfindings, there is a small positive fiscal multiplier in the case of transitory fiscal shocks. We find\nthat fiscal policy is effective in stabilising GDP in the presence of demand and supply shocks.\nFiscal policy helps to reduce the demand externality arising from nominal rigidities. In addition\nautomatic stabilisation via government transfers helps to smooth consumption of liquidityconstrained\nhousehold. Fiscal policy partly compensates the financial market distortion. With\ndistorted goods, labour and financial markets we find that the estimated fiscal policy rules reduce\nfluctuations in euro area GDP by about 14 percent.

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