Fiscal Deficits as a Source of Boom and Bust under a Common Currency

We investigate in depth, using predominantly analytical rather than numerical methods, the mechanisms triggered by a one-off debt-financed fiscal deficit in a small open economy with a shared currency. The economy incorporates staggered price setting and overlapping generations. Unsurprisingly, these cause the impact effect to be a boom, in the sense of price inflation and a positive output gap. However, contrary to what normally happens in New Keynesian models without extraneous dynamics, the boom later inevitably turns into a bust, i.e. price deflation and a negative output gap. Therefore, in this setting, while short-run Keynesian deficit-based fiscal stimulus ‘works’, it also provokes a medium-run ‘backlash’ in aggregate activity.