An Essay on Fiscal Policy Transmissions in Currency Union

The effect of changes in fiscal policy for open economies are distinct and different from their effects in closed economies. The main idea behiend this dissertation is to examine why and how these differences affect the choice of fiscal instrument designed to provide stimulative effects to an open economy in a currency union. In extending a two country model and adapting it to examine trade within a currency union, I provide a way to truncate rational expectations equilibrium involving two large countries with endogenous relative price determination in chapter three. Using this model, I show that a spending increase is less stimulative than a tax reduction, which takes advantages of movements in terms of trade to increase external demand along with a push to domestic demand. I further show that not all taxes exploit such movements in terms of trade and hence a critical part of tax led stimulus is the choice of tax instrument as explored in chapter four. These results indicate the relative effectiveness of taxes in open economies in comparison to spending. To make the comparison more relevant, I provide two extensions in chapter five. First, I examine this choice between a tax based stimulus with that of a spending based stimulus in an environment representative of the post 2008 recession. I show that in the absence of a monetary adjustment due to liquidity trap, spending increases are more effective than tax reductions. However, even in presence of a zero lower bound, tax reductions continue to be more effective than spending increases. The difference in presence of a lower bound is the effect of such tax reductions in trade balance. Second, I extend the design of an optimal fiscal plan to include a combination of taxes, targeting different aspects of transmission. Such a fiscal plan is more effective since it multiplies the effect of changes in terms of trade. I use a combination of VAT reductions coupled with export subsidies to depict a stimulus plan which maximizes output expansions in our model.