Government deficits, wealth effects and the price level in an optimizing euro-model

In the context of the current policy debate on the reform of European fiscal rules, there is wide consensus on the need to place more attention on debt-GDP ratios. Proposals have been made to alleviate fiscal pressure on Member States with relatively low public debts. The present paper gives support to this view. Economies with high public debt-GDP ratios are shown to experience larger price deviations after a fiscal expansion. These results are derived in a model, calibrated to euro area quarterly data, with capital accumulation, flexible prices and wealth effects in the presence of an independent monetary authority.