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.

Notes

¹ As B is more developed, we could alternatively consider β _B ζ _S  > β _S ζ _B (B has a better innovation capacity).

² The value of these firms, in turn, corresponds to the value of patents in use.

³ The competitive equilibrium threshold arises from profit maximization by perfectly competitive producers of final goods and by monopolist firms producing intermediate goods, and full-employment equilibrium in factor markets. Thus, B produces final goods n > and S produces final goods n ≤ .

⁴ Since S is not too backward (i.e. an appropriate taxonomy for B and S would be developed vs. developing, rather than developed vs. underdeveloped), it is predictable that inter-country differences in prices of final goods are of second order. Moreover, in the context of a monetary union, with single currency and common market, prices of tradable goods tend to be very similar, as well as national inflation rates.

⁵ That is, V(k, j, t) is the market value of the patent or the value of the monopolist firm, owned by consumers.

⁶ We solve the model numerically because the differential equation describing the path of G is non-linear and because we want to look at the path of adjustment of some fundamental variables.

⁷ Note that the values of the public deficit would be reduced if taxes were also considered.