Spillover effects in a monetary union: Why fiscal policy instruments matter

Using a two-country DSGE model, we analyze the spillover effects of fiscal policy in a monetary union. Based on a non-Walrasian labor market and a detailed fiscal sector, our analysis focuses on the relative cross-border effects of different kinds of fiscal instruments (expenditure side and revenue side). We show that different fiscal instruments produce quite different qualitative effects on the foreign economy. For instance, a public consumption expansion or a cut in social protection tax triggers a decrease in foreign GDP and an increase in foreign unemployment. On the contrary, an increase in transfers to households or a decrease in VAT leads to an increase in foreign GDP and a decrease in foreign unemployment. Moreover, we demonstrate that the choice of the fiscal instrument strongly affects the size of the spillover effects, meaning that different fiscal instruments also produce different quantitative effects on the foreign economy.