Endogenous growth and European fiscal rules

Abstract

We develop a general equilibrium endogenous growth model of a monetary union between two countries that differ in economic dimension and level of development. By solving transitional dynamics towards the steady state, we examine the impact of fiscal shocks that may lead to excessive deficits. Results suggest that the individual and the whole impact of such deficits depend on which country they occur. In such context, we argue that the small and less developed country should be allowed to temporarily run an excessive deficit, in order to improve economic convergence within the union.

Full text

Page 1

For Peer Review
Technological Change|Research and Development < O - Economic
Development, Technological Change, and Growth, O38 -
Government Policy < O3 - Technological Change|Research and
Development < O - Economic Development, Technological Change,
and Growth, H60 - General < H6 - National Budget, Deficit, and
Debt < H - Public Economics, E62 - Fiscal Policy|Public
Expenditures, Investment, and Finance|Taxation < E6 - Macro
Policy Formation, Macro Public Finance, Macro Policy, etc < E -
Macroeconomics and Monetary Economics, C61 - Optimization
Techniques|Programming Models|Dynamic Analysis < C6 -
Mathematical Methods and Programming < C - Mathematical and
Quantitative Methods







Endogenous Growth and European Fiscal Rules


Journal: Applied Economics
Manuscript ID: APE-06-0801.R1
Journal Selection: Applied Economics
Date Submitted by the
Author:
17-Jul-2007
Complete List of Authors: Afonso, Oscar; Universidade do Porto, Faculdade de Economia
Alves, Rui; Universidade do Porto, Faculdade de Economia
JEL Code:
O31 - Innovation and Invention: Processes and Incentives < O3 -
Keywords: Technological-Knowledge Gap, Monetary Union, SGP, Excessive
Editorial Office, Dept of Economics, Warwick University, Coventry CV4 7AL, UK
Submitted Manuscript
Author manuscript, published in "Applied Economics 41, 07 (2009) 849-858"
peer-00582207, version 1 - 1 Apr 2011
DOI : 10.1080/00036840701604503

Page 2

For Peer Review



Page 1 of 21
Editorial Office, Dept of Economics, Warwick University, Coventry CV4 7AL, UK
Submitted Manuscript
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
peer-00582207, version 1 - 1 Apr 2011

Page 3

For Peer Review
Endogenous Growth and European Fiscal Rules
Oscar Afonso*and Rui Henrique Alves
Faculdade de Economia, Universidade do Porto and CEMPRE†
First version – December 2006
This version – July 2007
Abstract
We develop a general equilibrium endogenous growth model of a monetary union
between two countries that differ in economic dimension and level of development. By
solving transitional dynamics towards the steady state, we examine the impact of fiscal
shocks that may lead to excessive deficits. Results suggest that the individual and the
whole impact of such deficits depend on which country they occur. In such context, we
argue that the small and less developed country should be allowed to temporarily run an
excessive deficit, in order to improve economic convergence within the union.
Keywords: Technological-Knowledge Gap; Monetary Union; SGP; Excessive Deficits;
Numerical Computation.
JEL Classification: O31, O38, H60, E62, C61.
*Corresponding author. E-mail address: oafonso@fep.up.pt. Address: Rua Dr. Roberto Frias 4200-464
Porto, Portugal. Fax: +351 225505050. Tel: +351 225571100.
†CEMPRE (Centro de Estudos Macroeconómicos e Previsão) is supported by Fundação para a Ciência e a
Tecnologia, Portugal.
Page 2 of 21
Editorial Office, Dept of Economics, Warwick University, Coventry CV4 7AL, UK
Submitted Manuscript
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
peer-00582207, version 1 - 1 Apr 2011

Page 4

For Peer Review
1
1. Introduction
With the creation of the European Monetary Union (EMU), the framework for the
definition and implementation of macroeconomic policies has dramatically changed.
Member-Countries have lost their exchange rate and money supply instruments and fiscal
policy has been restrained by binding rules aimed at avoiding excessive public deficits.
The need for fiscal discipline was justified by the potential external negative effects
that could result from excessive deficits run by any participant in the eurozone. These
effects (e.g., De Grauwe, 2005) included a possible increase in the interest rate of the
EMU, leading to possible pressures on the European Central Bank (ECB) to implement a
more expansionist monetary policy, thus leading to an increase in inflation.
Fundamentally, European fiscal rules have been put in place because of the need to keep
price stability (e.g., Baldwin and Wyplosz, 2006).
The above-mentioned rules included a maximum ceiling for the deficit to GDP ratio
(3%) and for the public debt to GDP ratio (60%) and were consecrated by the Maastricht
Treaty (1992). Further, the need for fiscal discipline has been improved by the rules of the
Stability and Growth Pact (SGP), which assumed a budgetary equilibrium (or even a small
budgetary surplus) as the fundamental goal in terms of the medium-run, in order to
preserve some margin for manoeuvre for fiscal policy in the case of a negative shock. The
SGP also established concrete sanctions to be applied to countries that maintain excessive
deficits and do not comply with Council recommendations (European Council, 1997).
Since the beginning, these rules have been the main object of discussion among
academics and politicians with regard to fiscal policy in the eurozone. Positions vary from
strong support for the current framework to proposals for important changes in it or even
to appeals for a radical change, which could include the federalisation of fiscal policy
(Alves and Afonso, 2007).
Page 3 of 21
Editorial Office, Dept of Economics, Warwick University, Coventry CV4 7AL, UK
Submitted Manuscript
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
peer-00582207, version 1 - 1 Apr 2011

Page 5

For Peer Review
2
Among the arguments put forward in favour of major changes in the original SGP,
we find the idea that fiscal rules would differ according to the level of development of the
Member-Countries and their economic dimension.
The goal of economic and social cohesion would require higher rates of real GDP in
the less developed countries, which in turn would require stronger public intervention and
would be compatible with temporary public deficit and debt ratios higher than those
proposed in the SGP. Moreover, several authors (e.g., Mills and Quinet, 2001; Brunila,
2002; Creel, 2003) suggested the substitution of current rules by the “golden rule” or the
introduction of rules concerning public expenses (and not strictly the public deficit).
In particular, some expenses related to public investment would be excluded from
the calculus of the relevant public deficit concerning the application of the “3 per cent”
rule, following the idea, expressed in some literature (e.g., Milbourne et al., 2003) that
public investment may help economic growth.
The other argument concerns external spillovers resulting from excessive deficits in
one country, as they would only occur or be relevant if such country was big (like
Germany), thus affecting financial markets and price stability in a relevant way.
The debate is not yet closed, but it may already have made a relevant contribution to
the recent SGP reform (European Council, 2005). The “new” SGP allows for a growing
number of circumstances that lead to a non-automatic application of sanctions, namely
considering a diversified kind of public expenses that may justify the non-compliance to
the “3 per cent” rule. As far as the present paper is concerned, it is relevant to note that,
within that set, expenses regarding R&D are included.
In order to analyse whether or not such kind of public expenses should be treated
differently and whether or not fiscal rules should differ between countries, we consider a
standard economic structure in endogenous R&D-growth theory, for two countries that
compose a monetary union. In each country, the production of perfectly competitive final
Page 4 of 21
Editorial Office, Dept of Economics, Warwick University, Coventry CV4 7AL, UK
Submitted Manuscript
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
peer-00582207, version 1 - 1 Apr 2011