Fiscal devaluation and labour market frictions in a monetary union

We assess the effects of a fiscal devaluation on economic and labour market conditions in a Member State of the euro area by simulating a monetary union model featuring labour markets with search and matching frictions. The fiscal authority of the Member State enacts a discretionary reduction in the social contribution rate for employers so that the corresponding revenues decrease by 1per cent of the before-shock (steady-state) nominal GDP. The measure is ex ante revenue neutral, because it is financed by a simultaneous discretionary increase in the consumption tax rate that generates additional ex ante revenues equal to 1 per cent of the before-shock GDP. The main results are as follows. First, GDP increases by 0.5 per cent, sustained by the increase in investment and net exports, while consumption decreases. Second, the unemployment rate decreases by 0.3 percentage points. Third, the trade balance improvement is equal to 0.3 per cent of GDP (the improvement in real net exports is partially offset by the deterioration in term of trade). Fourth, the results are rather robust to changes in key parameters.