Imbalances and fiscal policy in a monetary union

This paper analyses optimal fiscal policy within a model of a monetary union in which agents cannot perfectly insure themselves against country-specific shocks. I show that optimal cooperative fiscal policies consist in more than just stabilizing output gaps: policy makers can increase welfare by responding to sub-optimal intra-union imbalances. Numerical analysis reveals that if traded goods are little substitutable, optimal cooperative fiscal policies consist in setting government spending in each country so as to reduce intra-union imbalances, potentially at the expense of higher output gaps. Optimal fiscal policies reduce the welfare losses from business cycle fluctuations considerably.