Budgetary-Neutral Fiscal Policy Rules and External Adjustment

Large external imbalances and fragile fiscal positions have emerged as major policy challenges for the euro area in the financial crisis. The paper analyses whether shifting government purchases between tradable and non-tradable goods could help reduce external fluctuations without large swings in the overall fiscal stance. The policy rules considered are budgetary-neutral in the sense that the overall level of government expenditure is kept constant. We compare the policy rules to fiscal devaluation as a strategy to reduce external imbalances and find that state-dependent changes in the composition of government purchases between tradables and non-tradables can stabilise excessive fluctuations in the event of economy-wide supply and demand shocks. Contrary to fiscal devaluation, the expenditure-shifting rule faces a trade-off between stabilising domestic activity and enhancing household welfare, on the one hand, and reducing excessive fluctuations in external positions, on the other hand. The excess volatility of domestic variables associated less volatility in the external position implies welfare losses for standard specifications of household utility. The adverse welfare effect is absent in the case of fiscal devaluation. Copyright Springer Science+Business Media New York 2014