Fiscal Policy in a Currency Union at the Zero Lower Bound

Abstract

This paper constructs a two‐country core–periphery New Keynesian model of a currency union to address the interaction between the objectives of regionally directed fiscal policy constrained by a single currency and the aggregate use of fiscal policy in face of the zero lower bound (ZLB) on policy interest rates. We identify an optimal path of aggregate and relative fiscal policy responses to a negative region‐specific demand shock. Our results show that (i) in a monetary union, the optimal policy response to an asymmetric reduction in demand concentrated in the periphery always entails a relative shift of fiscal expenditure toward the worse‐affected regions, (ii) though no aggregate fiscal response is required outside the ZLB, and (iii) optimal union‐wide fiscal policy is expansionary at the ZLB. Therefore, optimal policy always entails an expansion in the periphery at the ZLB, but the optimal fiscal response in the core regions can be either expansionary or contractionary depending on the parameters of the model. However, (iv) fiscal expansion in the core is warranted if the periphery cannot implement an expansion due to constraints on public spending.