andersen unemployment

8/3/2019 Andersen Unemployment

http://slidepdf.com/reader/full/andersen-unemployment 1/17

European Journalof

POLITICALE u r o p e an J o u rn a l o f P o l it ic a l E c o n o m y E C O N O M Y

V o l . 1 1 (1 9 9 5 ) 2 7 - 4 3L S E V I E R

Unemployment and f i sca l po l i cy in an economic

and monetary union

T o r b e n M . A n d e r s e n * , J a n R o s e S c r e n s e nCentre for International Economics and Department of Economics, University of Aarhus,

DK-8000 Aarhus C, Denmark

Ac cep ted f or publ ica t ion Ju ly 1994

Abstrac t

We cons ider the need and room for demand management po l i c ies as a way to cont ro l

unem ploym ent in an Ec ono m ic and M onetary Un ion. The set up is a general equil ibr ium

model with imperfect ly compet i t ive product and labour markets . Balanced budget demand

management po l i c ies a re shown to a f f ec t employment , bu t they involve a beggar - thy-

ne ighbour e lement s ince ga ins in employm ent a re m atched by em ploym ent los ses in o ther

countr ies in the Union. Un coordinated pol ices are too expansionary, and opt ima l pol icies

require cons traints on the size of the public sec tor in the participating countries.

Keywords: I m p e r f e c t c o m p e t i t i o n ; F i sc a l p o l i c y ; M o n e t a r y u n i o n

JEL classification: D43; F 42; J51

1 . I n t r o d u c t i o n

A n i m p o r t a n t q u e s t i o n f o r c o u n t r ie s e n t e r in g i n t o a n E c o n o m i c a n d M o n e t a r y

U n i o n i s t h e e x t e n t to w h i c h p o l i c y s o v e r e i g n t y w i ll b e l o st . M o n e t a r y a n d

e x c h a n g e r a t e p o l i c i e s w i l l n o l o n g e r b e a v a i l a b le f o r t h e i n d i v i d u a l c o u n t r i e s ,

l e a v i n g f i s c a l p o l i c y i n s t r u m e n t s a d o m i n a n t r o l e . M o r e o v e r , f i s c a l p o l i c y m u s t b e

* C o r r e s p o n d i n g a u t h o r. C o m m e n t s b y H e n r i k J e n s e n , H u w D i x o n , t w o a n o n y m o u s r e f e re e s an d

p a r t i c ip a n t s a t a c o n f e r e n c e a rr a n g e d b y C I E a t t h e U n i v e r s i ty o f A a r h u s a n d a t t h e s e m i n a r o n ' S m a l l

C o u n t r i e s a n d t h e E M U ' a t t h e U n i v e r s i t y o f J o e n s u u , i n p a r t i c u la r t h e d i s c u s s a n t H e i k k i T a i m i o a r e

g r a t e fu l l y a c k n o w l e d g e d .

0 1 7 6 - 2 6 8 0 / 9 5 / $ 0 9 . 5 0 © 1 9 95 E l s e v i e r S c i e n c e B . V . A l l r i g h ts r e s e r v e d

S S DI 0 1 7 6 - 2 6 8 0 ( 9 4 ) 0 0 0 5 4 - 9



28 T.M. Andersen, J.R. SC rensen / European Journal of Political Economy 11 (1995) 27- 43

coord ina ted to ensure the sus t a inab i l i t y o f a m one ta ry un ion im ply ing cons t r a in t s

on pub l i c deb t and de f i c i t s o f i nd iv idua l coun t r i e s ( see e .g . T he D e lo r s R epor t ,

1989) . I t m igh t thus be f ea red tha t t he coun t r i e s w i l l l o se the poss ib i l i t y o fa d d r e s s in g p o l i c y p r o b l e m s , l i k e u n e m p l o y m e n t , e f f e c ti v e l y .

A n othe r v i ew poin t i s t ha t m os t o f t hese po l i cy in i ti a t ives w i l l be s uper f luou s in

a U nion s ince the inc reased f l ex ib i l i ty and co m p e t i t i on induced by in t egra t ion w i l l

e l im ina te the p rob lem s usua l ly ca l l ing fo r po l i cy in t e rven t ion . T h i s w ould , fo r

i n s ta n c e , b e t h e c a s e i f u n e m p l o y m e n t i s c au s e d b y e x c e s s i v e w a g e c l a i m s . W i th

in tens i f i ed com pe t i t i on in p roduc t m arke t s , i t becom es m ore d i f f i cu l t fo r w orker s

to a sk fo r w ages in excess o f fo re ign w ages , s ince tha t w o uld im ply subs tan t ia l

em ploy m e nt los ses ( see A nd er sen and S 0rensen , 1992) . I f t h i s p rocess t akes us to

a s i tua t ion c lose to tha t o f pe r fec t com pe t i t i on , i t fo l low s tha t unem ploym ent due

to excess ive w age c l a im s w i l l d i sappear . I t i s beyond doub t tha t t he com ple t ion o ft h e i n t e r n a l m a r k e t , a n d t h e e s t a b l i s h m e n t o f a n E c o n o m i c a n d M o n e t a r y U n i o n ,

w i l l enhance co m p e t i t i veness in p roduc t m a rke t s , and thus induce w age r es tr a in t.

A t the sam e t im e , i t i s a l so obv ious tha t t he bench m a rk case o f pe r fec t com pe t i t i on

i s un l ike ly to m a te r i a l i ze . F i rm s and l abour un ions w i l l s t i l l have m arke t pow er in

the U nion , because p roduc t s r em ain im per fec t subs t i tu t e s , and the p rob lem of how

t o c o m b a t u n e m p l o y m e n t i s n o t m a d e o b s o l et e .

T h i s p a p e r c o n s i d e r s t h e r o l e o f t r a d i t i o n a l d e m a n d m a n a g e m e n t p o l i c i e s f o r

u n e m p l o y m e n t . T h e d i s c u s s i o n o f t h e i m p l i c a t i o n s f o r f i s c a l p o l i c y o f E u r o p e a n

in tegra t ion has p r im ar i ly focu sed on the l im i t s t o t ax po l i c i e s induc ed by inc reased

m obi l i ty o f the t ax base , and the need to avo id unsus ta inab le budge t de f i c i t s . L essa t t en t ion has been d i r ec t ed to dem and m anagem ent po l i cy in i t s ro l e a s s t ab i l i za -

t ion ins t rum ent .

In the p resen t paper , w e focus on the e f f ec t s o f f i s ca l po l i cy in the fo rm of

ba lanced budge t changes in pub l i c consum pt ion , a po l i cy ins t rum ent w hich i s

o f t en used in e f fo r t s to con t ro l unem ploym ent . T he se t t ing i s a genera l equ i l ib r ium

m o d e l f o r a n E c o n o m i c a n d M o n e t a r y U n i o n . I t i s s h o w n t h a t d e m a n d m a n a g e -

m en t po l i c i e s a re e f f ec t ive , bu t i nc ludes a subs tan t i a l beggar - thy -ne igh bou r e l e -

m ent . In the p resen t m o de l se t -up th i s e f f ec t is so s t rong tha t an inc rease in

e m p l o y m e n t o b t a i n e d i n a g i v e n c o u n t r y i s e x a c t l y m a t c h e d b y a f a l l i n e m p l o y -

m ent in the o the r coun t r i e s .

D i f f e r e n c e s b e t w e e n n a t io n a l a n d U n i o n - w i d e i n c e n ti v e s to c h a n g e s i n g o v e r n -

m ent dem and a r i se f rom a t e rm s o f t r ade and an ac t iv i ty e f f ec t . T he t e rm s o f t r ade

e f fec t i s w e l l -know n in the l i t e r a tu re ( see e .g . T urno vsky , 1988 ; D evere ux , 1991) ,

w hereas the ac t iv i ty e f f ec t i s usua l ly e l im ina ted by as sum ing pe r fec t com pe t i t i on

and fu l l em ploym ent . In the p resen t se t t i ng , d i s to r t ions caused by im per fec t

c o m p e t i ti o n i m p l y t h a t a c ti v i ty b e c o m e s t o o l o w f r o m a s o c i a l p o in t o f v i e w , a n d

hence the re a re ga ins f rom expand ing ac t iv i ty .

U ncoord ina ted f i sca l po l i c i e s a re too expans ionary caus ing w e l fa re los ses , and ,

t h e r e fo r e , c o o r d i n a t io n o f b a l a n c e d b u d g e t d e m a n d m a n a g e m e n t p o l i c ie s w i th i n a n

E c o n o m i c a n d M o n e t a r y U n i o n i s n e e d e d . T h e n e e d f o r c o o r d i n a t i o n i s s h o w n t o



T.M. Andersen, J.R. SCrensen European Journal of Political Economy 11 (1995) 27-43 29

b e l a r g e r th e g r e a t e r th e n u m b e r o f c o u n t r ie s p a r t i c i p a t in g i n t h e U n i o n , b u t , o n t h e

o t h e r h a n d , t h e u n i l a t e r a l g a i n f r o m d e v i a t i n g f r o m a c o o r d i n a t e d p o l i c y i s a l s o

i n c r e a s i n g i n t h e n u m b e r o f c o u n t r i e s . T h i s s u g g e s t s t h a t t i g h t e r r u l e s h a v e t o b ei m p o s e d o n f i s c a l p o l i c i e s t o m a k e t h e U n i o n w o r k , a n d t h a t t h e U n i o n h a s a n

o p t i m a l s i z e i n t e r m s o f t h e n u m b e r o f p a r t i c ip a t i n g c o u n t ri e s . T h i s r e s u l t s e e m s t o

b e i n c o n t r a s t t o C h a r i a n d K e h o e ( 1 9 9 0 ) , w h o s h o w t h a t t h e e q u i l i b r i u m w i t h

u n c o o r d i n a t e d f i s c a l p o l i c y c o n v e r g e t o t h e e q u i l i b r i u m w i t h c o o r d i n a t e d f i s c a l

p o l i c y a s t h e n u m b e r o f c o u n t r i e s i n c r e a s e s . H o w e v e r , i n t h e i r m o d e l , i t i s

a s s u m e d t h a t th e c o u n t r ie s p r o d u c e p r o d u c t s w h i c h a r e p e r f e c t s u b s t it u te s i m p l y i n g

t h a t t h e p r o d u c t m a r k e t p o w e r o f t h e i n d i v i d u a l c o u n t r i e s d e c r e a s e s a s t h e n u m b e r

o f c o u n t r i e s i n c r e a s e s . T h i s i s n o t t h e c a s e i n o u r m o d e l w h e r e i t i s a s s u m e d t h a t

t h e c o u n t r i e s p r o d u c e p r o d u c t s w h i c h a r e i m p e r f e c t s u b st it u te s . 1 T h i s s u g g e s t s

t h a t i n c r e a s i n g m e m b e r s h i p i n g e n e r a l h a s a n a m b i g u o u s e f f e c t o n t h e n e e d f o rp o l i c y c o o r d i n a t io n .

T h e f i n d i n g o f g a i n s f r o m p o l i c y c o o r d i n a t io n i s, o f c o u r s e , n o t n e w , a n d h a s

b e e n e x t e n s i v e l y a n a l y z e d ( s e e C a n z o n e r i a n d H e n d e r s o n , 1 9 9 1 ; C h a n g , 1 9 9 0 ;

D e v e r e u x , 1 9 9 1 ; T u r n o v s k y ( 1 9 8 8 ) . 2 T h e n e w i n s ig h t o f t h e p r e s e n t p a p e r is th a t

t h e n e e d f o r p o l i c y i n t e rv e n t i o n i s g r o u n d e d i n w e l f a r e t e r m s w i t h in a g e n e r a l

e q u i l i b ri u m m o d e l w h e r e p o l i c y - m a k e r s h a v e a n i n c e n t iv e to in c r e a s e e m p l o y -

m e n t . T h i s h a s t h e a d v a n t a g e o f n o t o n l y m a k i n g e x p l i c i t t h e i m p e r f e c t i o n s

c a u s i n g u n e m p l o y m e n t b u t a l so i n f o u n d in g p o l i c ie s a i m i n g a t e m p l o y m e n t o n

w e l f a r e t e r m s . T h e p a p e r t h u s b r i n g s t o g e t h e r t w o s t r a n d s o f l i t e r a t u r e , n a m e l y a d

h o c m o d e l s b a s e d o n n o m i n a l w a g e i ne r ti a a s a c a u s e o f u n e m p l o y m e n t a nd

a r b i t r a r y p o l i c y o b j e c t i v e s , a n d g e n e r a l e q u i l i b r i u m m o d e l s a l l o w i n g w e l f a r e

c o m p a r i s o n s b ut p r e s u m i n g f u l l e m p l o y m e n t .

T h e p a p e r is o r g a n i s e d a s f o l lo w s . T h e d e t a i l s o f t h e m o d e l b u i ld i n g o n D i x o n

( 1 9 9 1 ) i s s e t o u t in S e c t i o n 2 . T h e e m p l o y m e n t c o n s e q u e n c e s o f f is c a l p o l ic y a r e

ana l yzed i n Sec t i on 3 , w h i l e op t i m a l f i s ca l po l i c i e s a r e cons i de r ed i n Sec t i on 4 . A

f e w c o n c l u d i n g r e m a r k s a r e g i v e n i n S e c t i o n 5 .

2 . T h e m o d e l

W e a s s u m e t h a t t h e r e a r e n c o u n t r i e s ( o r r e g i o n s ) i n a m o n e t a r y u n i o n w i t h a

c o m m o n m o n e y m a r k e t. T h e c o u n tr ie s d o n o t h a v e d i sc r e ti o n a ry p o w e r t o c h a n g e

1 In fact Ch ari and Kehoe (1990) have a small section where they show that, if the countries produceproducts wh ich are not perfe ct substitutes, then the nonco operativeequilibrium does not conv erge tothe cooperativeequilibrium as the num ber of countries increases. Ke hoe (1987) and Chang (1990) getresults similar to ou rs, but in their m odels the externality of dom estic fiscal policy on foreign countrieswo rks through the international capital market, wh ereas, in our m odel it wo rks through the produ ct andlabour markets.

2 Othe r analyses question the optim ality of international policy coordination, see e.g. K eho e (1989)

and Ro go ff (1985).



3 0 T .M . A n d e r s e n , J .R . S C r e n s e n / E u r o p e a n J o u r n a l o f P o l i t i c a l E c o n o m y 1 1 ( 1 9 9 5 ) 2 7 - 4 3

t h e i r p a r t o f t h e m o n e y s u p p l y , a n d t h e n o m i n a l e x c h a n g e r a t e s a r e f i x e d . T h e s e

a s s u m p t i o n s i m p l y t h a t b a l a n c e d b u d g e t d e m a n d m a n a g e m e n t p o l i c i e s c a n b e

s tud ied in a con tex t d i s rega rd ing f inanc ia l a spec t s .I n e a c h c o u n t r y t h e r e i s a n u mb e r o f s e c t o r s p r o d u c i n g p r o d u c t s wh i c h a r e

i mp e r f e c t s u b s t i t u t e s f o r t h e p r o d u c t s p r o d u c e d i n t h e o t h e r c o u n t r i e s . F o r n o t a -

t i o n a l s i mp l i c i t y , we n o r ma l i z e t h e n u mb e r o f s e c t o r s i n e a c h c o u n t r y t o o n e , a n d

i t ma y b e i n t e r p r e t e d a s a r e p r e s e n t a t i v e s e c t o r . T h e f i r ms d e c i d e o n t h e i r

p r o d u c t i o n t a k i n g t h e b e h a v i o u r o f a l l o t h e r f i r ms a s g i v e n , a n d i n e a c h s e c t o r

t h e r e i s a mo n o p o l y l a b o u r u n i o n wh i c h u n i l a t e r a l l y s e t s t h e n o mi n a l wa g e r a t e .

F o r s i mp l i c i t y , we a s s u me t h a t t h e c o u n t r i e s a r e c o mp l e t e l y s y mme t r i c .

2.1. The households

I n e a c h c o u n t r y i ( i = 1 . . . . n ) , t h e r e a r e H 1 wo r k e r s , a n d H 2 c a p i t a l is t s

( H 1 + H 2 = H ) . T h e c a p i t a li s t s d o n o t w o r k , b u t e a c h c a p i t a li s t r e c e i v e s a s h a r e

~b~(F.~b~ = 1) of to ta l pro f i ts in cou ntry i (equal to H i ) . Th e w ork ers a l l supp ly

o n e u n i t o f l a b o u r. I f a wo r k e r i s e mp l o y e d , h e r e c e i v e s a n o m i n a l wa g e W i, b u t

t h e r e is a d is u t il i ty o f wo r k ( d ) . I f a wo r k e r i s u n e m p l o y e d , h e r e c e i v e s a n o mi n a l

u n e m p l o y m e n t b e n e f i t B . 3 Ho u s e h o l d h i n c o u n t r y i h a s a n i n it ia l mo n e y

b a l a n c e M~o , a n d p a y s a l u mp - s u m t a x t ~ . T h e u t i l i t y i s g i v e n b y 4

- - T - 1 - c j

O < c < l , O < d < l , f ' > O , f " < O , f ' ( O ) = o o , f ' ( o o ) = O , ( 1 )

wh e r e C~ i s a c o n s u mp t i o n i n d e x :

n

• Y - I t ' i , ~ l / , ,C t h = I J l . [ X r h ] ;

r = l

x~h i s t h e c o n s u m p t i o n o f p r o d u c t r ; M~ i s t h e m o n e y s to c k ; N~ i s th e

e m p l o y m e n t l ev e l (o n e i f th e c o n s u m e r i s an e m p l o y e d w o r k e r , a n d z e r o i f t he

c o n s u me r i s u n e mp l o y e d o r a c a p i t a l i s t ) ; g i i s p u b l i c c o n s u mp t i o n i n c o u n t r y i ,

a n d we a s s u me t h a t t h e ma r g i n a l u t i l i t y o f p u b l i c c o n s u mp t i o n i s p o s i t i v e b u tdec reas ing ; f ina l ly , P i s the cos t o f l iv ing index de f in ed as

n

p = H e r l / n

r = l

wh e r e P r i s t h e p r i c e o f p r o d u c t r .

3 N o t e t h a t a h o u s e h o l d o n l y w a n t s t o w o r k i f ( W i - B ) / P >~ d , w h i c h w e a s s u m e . T h i s a l s o

i m p l i e s th a t d < 1 .

4 T h i s u t i l i t y f u n c t i o n m a y b e i n t e r p r e t e d a s a n i n d i r e c t u t i l i t y f u n c t i o n d e r i v e d f r o m a n i n t e r t e m p o r a l

m a x i m i z a t i o n p r o b l e m w i t h m o n e y a s th e o n l y p o s s i b l e s to r e o f s a v i n g s (s e e e . g. B e n a s s y , 1 9 8 2 ) .



T.M. Andersen, J.R. SC rensen European Journal of Political Econom y 11 (1995) 27 -43 31

No te t ha t t he n ( i . e . num ber o f p roduc t s ) , in f ron t o f C~ in t he u t il i ty func t ion ,

i s a c o n v e n i e n t n o r m a l i z a t i o n w h i c h i m p l i e s t h a t th e m a r g i n a l u t il it y o f i n c o m e

b e c o m e s i n d e p e n d e n t o f th e n u m b e r o f p r o d u c t s (s e e e .g . B l a n c h a r d a n d K i y o t a k i,1987) . 5

T h e b u d g e t c o n s t r a i n t o f t h e c o n s u m e r i s

i ~ iPrX~h q-M ~ q- t h -~Moh + Y ' h ( 2 )

r = l

w h e r e y ~ is e q u a l t o w i , B o r ~b~ H f o r a n e m p l o y e d w o r k e r , a n u n e m p l o y e d an d

a cap i t a l is t , r e spe c t ive ly . M ~ h i s th e i n i ti a l m o n e y s t o c k o f c o n s u m e r h .

B y m a x i m i z i n g ( 1 ) w i t h r e s p e c t t o c o n s u m p t i o n a n d m o n e y , a n d s u b j e c t to ( 2 ) ,

i t f o l l ows tha t 6

1 c_ ~ _ _ M i i

Xr i Pr n ( Oh + y h - - t ~ ) , ( 3 )

i _ (1 - c ) ( M g h + y ~ - - t ~ ) . ( 4 )h -

For l a t e r u se , we f i nd the i nd i r ec t u t i l i t y func t ion by in se r t i ng these demand

func t ions i n to (1 ) :

M ~ h + y i - - t i hV ; P d N / + f ( g i ) . ( 5 )

T h e d e m a n d f u n c t i o n ( 3 ) i m p l i e s a p r i c e e l a s t i c i t y o f u n i t y , a n d w e n o t e t h a t

d e m a n d d o e s n o t d e p e n d o n t h e s o u r c e o f t h e c o n s u m e r s ' i n c o m e . T h e s e a s s u m p -

t i o n s a r e a d o p t e d f o r a n a l y t ic a l c o n v e n i e n c e . H o w e v e r , t h e a s s u m p t i o n t h a t t h e r e i s

s o m e d e g r e e o f i m p e r f e c t s u b s t i t u t i o n b e t w e e n p r o d u c t s p r o d u c e d i n d i f f e r e n t

coun t r i e s i s c ruc i a l s i nce i t imp l i e s marke t power t o f i rms and thus t o un ions ( s ee

A n d e r s e n a n d S ~ r e n s e n , 1 9 9 2 ) .

2 .2 . T h e g o v e r n m e n t

W e w i l l a s s u m e t h a t t h e g o v e r n m e n t i n c o u n t r y i s o l el y d e m a n d s t h e p r o d u c t

p r o d u c e d i n th i s c o u n t r y . T h i s i s a t v a r ia n c e w i t h t h e p r in c i p l e o f t h e E u r o p e a n

C o m m u n i t y t h a t p u b l i c d e m a n d s h o u l d b e e x t e n d e d t o a l l f i r m s w i t h o u t a n y

na t iona l p r io r i t i e s . I t i s , however , an imp l i ca t i on o f t he p re sen t mode l t ha t no

5 W i t h o u t t h i s n o r m a l i z a t i o n , th e m a r g i n a l u t i li t y o f i n c o m e w o u l d b e decreasing i n th e n u m b e r o f

p r o d u c t s .

6 N o t e t h a t e m p l o y m e n t a n d p u b l i c c o n s u m p t i o n a r e n o t c h o i c e v a r i a b l e s f o r t h e i n d i v i d u a l

c o n s u m e r s .



32 T.M. Andersen, J.R. SCrensen / E uropean Journal of Political Econom y 11 (1995) 27 -4 3

s i n g l e g o v e r n m e n t h a s a n i n c e n t i v e t o d o s o ( i f i t i s c o n c e r n e d a b o u t e m p l o y m e n t ) ,

s e e b e l o w . W i t h s o m e p r o d u c t d i f f e r e n t i a t i o n l e f t i n a n E M U , i t i s d i f f i c u l t t o

a v o i d t h is i n c e n t i v e i n p u b l i c c o n s u m p t i o n , a n d a n y t h i n g t o p r e v e n t t h is w o u l dc o m e c l o s e t o c o o r d i n a t e d f i s c a l p o l i c i e s a s d i s c u s s e d l a t e r . A l t h o u g h t h i s a s s u m p -

t i o n i s e x t r e m e , t h e q u a l i t a t i v e r e s u l t s h o l d a s l o n g a s th e s h a r e o f p u b l i c

c o n s u m p t i o n b e i n g d i r e c t e d t o t he d o m e s t i c p r o d u c t i s l a r g e r th a n f o r p ri v a t e

c o n s u m p t i o n .

T h e g o v e r n m e n t i s a s s u m e d t o c h o o s e n o m i n a l g o v e r n m e n t e x p e n d i t u r e s ( G i ) ,

a n d i t a l s o p a y s t h e u n e m p l o y m e n t b e n e f i t . T h e b u d g e t c o n s t r a i n t i s

G i + ( H 1 - N i ) B - T i = O. ( 6 )

I t i s a s s u m e d t h a t t h e g o v e r n m e n t d o e s n o t h a v e a n y p o s s i b i l i ty f o r f in a n c i n g ad e f i c it t h r o u g h a n i n c r e a s e i n t h e m o n e y s u p p l y , 7 w h i c h i s i n a c c o r d a n c e w i t h t h e

r u l e s u n d e r l y i n g t h e E u r o p e a n E c o n o m i c a n d M o n e t a r y U n i o n .

H a v i n g c h o s e n g o v e r n m e n t d e m a n d t h e re i s o n e d e g r e e o f f r e e d o m l ef t t o t h e

g o v e r n m e n t i n c h o o s i n g e i t h er t h e l ev e l o f u n e m p l o y m e n t b e n e f it s o r t a x es t o

b a l a n c e t h e b u d g et . I n th e p r o c e e d i n g , w e s h a ll a s s u m e t h at u n e m p l o y m e n t

b e n e f i t s a r e f i x e d a t a g i v e n r e a l v a l u e , i . e . B / P = c o n s t a n t , s

B y u s i n g t h e b u d g e t c o n s t r a i n t o f t h e g o v e r n m e n t i n ( 6 ), a n d s u m m a r i s i n g t h e

e x p e n d i t u r e s o f t h e g o v e r n m e n t a n d t h e c o n s u m e r s i n a l l c o u n t r i e s , w e f i n d t h a t

t h e t o t a l e x p e n d i t u r e o n p r o d u c t i i s

c (P i X i = G i + - M o + E P j X j - G j ( 7 )n j = l j =

w h e r e X i i s t o ta l d e m a n d o f p r o d u c t i , a n d M 0 is t he t o t a l m o n e y s u p p l y i n th e

m o n e t a r y u n i o n . N o t e t h a t t o t a l e x p e n d i t u r e o n p r o d u c t j a n d t o t a l i n c o m e i n t h e

c o u n t r y p r o d u c i n g p r o d u c t j a r e e q u a l. S o l v i n g f o r e x p e n d i t u r e s i n s e c t o r i , w e

f i n d t h a t

c 1

- - - - - M 0 . ( 8 )i x i Gi + 1 - c n

W e s e e t h a t t o ta l e x p e n d i t u r e s o n p r o d u c t i i s i n c r e a s i n g i n G i. T h e r e a s o n f o r t h i s

is th a t b a l a n c e d b u d g e t d e m a n d m a n a g e m e n t p o l i c ie s s w i tc h d e m a n d f r o m f o r e ig n

p r o d u c e d t o w a r d s d o m e s t i c a l l y p r o d u c e d g o o d s .

7 It also rules out any dynam ic inefficiencies of fiscal policy through the international capital marketas in e.g. Cha ng (1990).

s In the o pposite case with G i fixed and B as the choice variable, it is noted that changes in B do

not affect demand , and the o nly effect wo uld be on w age setting. In the present mo del lowering Bwould lower w age demands and thus unemployment.



T.M. Andersen, J.R. SCrensen European Journal of Political Econom y 11 (1995) 27-43 33

2 . 3 . T h e f i r m s

W e a s s u m e t h a t t h e r e a re m f i rm s i n c o u n t r y i , a n d e a c h f i r m c h o o s e s o u t p u tg i v e n t h e w a g e w i . T h e p r o d u c t i o n f u n c t i o n o f f ir m k i n c o u n t r y i is g iv e n a s

X ] ~ = N / , + f , i f N~ > 0

X ~ = 0 , i f N ~ - 0 i - ( 9 )

w h e r e N ; i s e m p l o y m e n t in f i rm k , a n d f > 0 i s a c o n s ta n t . T h e c o n s t a n t s e r v e s

the ro l e o f ensu r ing dec reas ing r e tu rns t o l abour i n t he s ense t ha t t he ave rage

p r o d u c t i v i t y o f l a b o u r i s d e c r e a s in g i n e m p l o y m e n t ( se e a l s o f o o t n o t e 8 ).

In t he fo l l owing , we cons ide r t he case where f i rms a r e ac tua l ly p roduc ing ( i . e .

N ; > 0 ) , a n d b e l o w w e s h o w t h a t t h e w a g e r a t e s a r e d e t e r m i n e d s u c h t h a t t h i s i s

a l w a y s t h e c a s e . T h e f i r m s a r e a s s u m e d t o m a x i m i z e p r o f it s f o r a g iv e n p r i c e l e v e l

P , s o t h e y i g n o r e t h e ( v e r y s m a l l) e f f e c t t h e ir b e h a v i o u r m a y h a v e o n t h e g e n e r a l

p r i ce l eve l . Because o f the cons t an t m arg ina l p rodu c t iv i t y o f l abour , and the un i t

e l a s ti c d e m a n d f o r t h e p r o d u c t p r o d u c e d i n c o u n t r y i , it f o ll o w s t h a t th e C o u r n o t

equ i l i b r ium i s cha rac t e r i zed by ( see a l so Dixo n , 1991 )

1 1P i = - - - w i , / ~ = - - . ( 1 0 )

1 - / z m

S o t h e r e is a c o n s t a n t m a r k - u p o f p r ic e s o v e r w a g e s , a n d /x i s L e r n e r ' s d e g r e e o f

m o n o p o l y w h i c h i s d e c r e a s i n g in t h e n u m b e r o f fi r m s .

F r o m ( 1 0 ) i t f o l l o w s th a t t h e re a l p r o d u c e r w a g e i n c o u n t r y i i s g i v e n a s 1 - / z ,

a n d u s i n g t h i s a n d t h e p r o d u c t i o n f u n c t i o n g i v e n i n ( 9 ) , t h e l a b o u r d e m a n d

func t ion i s ea s i l y found to be

K i

N i = W - -- -7 -F , r i = ( 1 - t x ) p i x i. ( 1 1 )

w h e r e F = m f

2 . 4 . W a g e - d e t e r m i n a t i o n

I n e a c h c o u n t r y t h e re i s a l a b o u r u n i o n w h i c h o r g a n i z e s a l l w o r k e r s , a n d t h e

u n i o n s a r e a s s u m e d t o m a x i m i z e t h e e x p e c t e d u t i l i t y o f a r e p r e s e n t a t i v e m e m b e r .

Th i s i s equ iva l en t t o max imiz ing the fo l l owing u t i l i t a r i an ob jec t ive func t ion :

V i = N i - 0 ( 1 2 )P

w h e r e 0 i s t h e d i su t il it y o f w o r k p l u s t h e r e a l v a l u e o f l o s t u n e m p l o y m e n t b e n e f i t s

w h e n w o r k i n g ( i . e . 0 = d + B / P = cons tant ) .

T h e u n i o n s e ts t h e w a g e r a t e u n i la t e ra l ly ( i. e. w e a p p l y t h e m o n o p o l y u n i o n

m o d e l , s e e e . g . O s w a l d ( 1 9 8 5 ) ) , a n d w e a s s u m e t h a t i t i s a l w a y s a b o v e t h e w a g e

l e a d i n g t o f u l l e m p l o y m e n t ( i . e . N i < H 1 ) . H e n c e , t h e u n i o n m a x i m i z e s ( 1 2 )



3 4 T.M. Andersen, J.R. SOrensen / European Journal of Political Economy 11 (1995) 27-43

sub jec t t o t he l abour demand g iven in (11 ) , and a s suming tha t t he un ion cons ide r s

the con sum er p r i ce i ndex to be g iv en ( i .e . t he un ion ignores t he sma l l e f f e c t W i

has on the co nsum er p r i ce i ndex) , i t t u rns ou t tha t 9

Tha t i s , t he wage i s s e t a s a mark -up on aggrega t e p r i ces , where t he mark -up i s

inc reas ing in t he r e se rva t ion wa ge o f t he un ion 0 and the l eve l o f l abour dem and

( K i / F ) . Note t ha t (13 ) does no t imp ly a cons t an t r ea l wage .

W i* = N• 1( K i ) 1 / 2 K 1 / 2 ( 1 4 )

w h e r e NB = F ( 1 - / z ) / 0 , a n d K i s t h e g e o m e t r i c m e a n o f K j i n t h e n c o u n t ri e s .F r o m ( 1 1 ) a n d ( 1 4 ), i t f o l l o w s th a t th e e m p l o y m e n t in s e c t o r i b e c o m e s

N i* = g B ( k i ) 1 /2 - F ( 1 5 )

w h e r e k i = Ki /g .

3 . E m p l o y m e n t c o n s e q u e n c e s o f f is c a l p o li cy

In t he p re sen t s e t t i ng , w i th imper fec t compe t i t i on in bo th p roduc t and l abourmarke t s , t he re migh t be a po l i ti ca l des ir e t o try t o i nc rease em ploy m en t by dem and

managemen t po l i c i e s . Th i s i s o f cou r se c lose ly r e l a t ed t o t he d i scuss ion o f t he

e f f i c i e n c y o f d e m a n d m a n a g e m e n t p o l i c i e s e s p e ci a l ly i n r e l a t io n t o K e y n e s i a n

v i e w p o i n ts . I n g e n e r a l , d e m a n d m a n a g e m e n t p o l i c ie s a r e n o t i n - e f f e c t iv e i n o p e n

eco nom ies (s ee e .g . M ar s ton (1985) ) , bu t i t is no t c l ea r wh ich imp l i ca t i ons t h i s

h a v e f o r h o w s u c h p o l i c i e s w i l l w o r k i n a n E c o n o m i c a n d M o n e t a r y U n i o n .

T h e e f f e c t o n c o u n t r y i ' s e m p l o y m e n t le v e l o f c h a n g e s i n th a t c o u n t r y ' s l e v e l o f

pub l i c dem and i s, by use o f (15 ) and the de f in i t i on o f K i i n (11 ), f oun d to be

- - N .( ki) - 1 / 2 1 - > o . ( 1 6 )

9 I t i s e a s il y s e e n t h a t F > 0 i s n e c e s s a r y i n o r d e r t o g e t a f in i t e w a g e r a t e . T h i s i s b e c a u s e t h e p r i c e

e l a st i ci ty o f t h e p ro d u c t d e m a n d i s o n e , w h i c h g i v e s r i s e to a w a g e e l a s ti c it y o f e m p l o y m e n t w h i c h i s

o n e u n l e s s F > 0 . H e n c e , a n o t h e r w a y t o g e t a f i n i te w a g e r a t e w o u l d b e t o a s s u m e a u t i li t y f u n c t i o n

w h i c h g i v e s r i s e t o a p r o d u c t d e m a n d w i t h a p r i c e e l a s t i c i t y g r e a t e r t h a n o n e ( s e e e . g . B l a n c h a r d a n d

K i y o t a k i , 1 9 8 7 ). H o w e v e r , t h is w o u l d c o m p l i c a te t h e m o d e l , c o n s i d e r a b l y , w i t h o u t c h a n g i n g o u r m a i n

c o n c l u s i o n s . D i x o n ( 1 9 9 1 ) a p p l i e s a th i r d w a y t o a c h i e v e a f i n i t e w a g e r a t e a s h e a s s u m e s th a t t h e

a v e r a g e p r o d u c t i v i t y o f l a b o u r i s c o n s t a n t ( i. e . X ~ = N ~ ) , w h i l e t h e o b j e c t i v e f u n c t i o n o f t h e u n i o n h a s

a S t o n e - G e a r y s p e c i f i c a t i o n ( i . e . V=(N i - FX wi / p - 0), w h e r e F i s s o m e m i n i m u m a c c e p ta b l e

e m p l o y m e n t f o r t h e u n i on .



T.M. Andersen, J.R. SCrensen European Journal of Political Econom y 11 (1995) 27 -43 3 5

B u d g e t n e u t r a l d e m a n d m a n a g e m e n t p o l i c i e s a f f e c t e m p l o y m e n t , a n d i f t h e

gove rnm ent in coun t ry i i nc reases expendi tu res , t he em ploym ent i n t h is coun t ry

inc reases . On the o the r hand , t h i s has r epe rcuss ions t o o the r coun t r ie s , and we f i ndthat

ONJ---~* - 1N ~( kJ )l /2 (1 -1 x-- ---- -~ ) < 0 . ( 1 7 )i)G i 2 n K i

Exp ans ionary po l i c ie s i n coun t ry i l ower s em ploym ent in a l l o the r coun tr i e s. 10

To see t he ne t e f f ec t on overa l l employment , i t i s use fu l t o cons ide r t he

sym me t r i c case where a l l coun t r i e s have t he same l eve l o f governm ent deman d

(i.e. G i i s the sam e in a l l count r ies) , imp lying that k i = 1 for a l l count r ies , and

thus

~ ON *

j = l O G ' = 0 . ( 1 8 )

I t f o l low s tha t t o t a l em ploym ent in t h i s case i s una f f ec t ed by t he l eve l o f

government demand . There i s fu l l c rowding ou t s i nce p r i ces i nc rease by so much

as t o l eave r ea l deman d unchang ed . Th i s e s sen t i a ll y wo rks by r educ ing r eal

ba l ances sh i f t i ng demand f rom pr iva t e t o pub l i c consumpt ion .

An impl icat ion of th i s resul t i s that , i f a l l count r ies s imul taneously increase

government expendi tu res , t he re w i l l no t be any e f f ec t on employment i n any

count ry, i . e .

i )N i *

0 G ' I G i = c = 0 . ( 1 9 )

U n t il n o w w e h a v e f o c u s e d o n t h e e f fe c t s o f n o m i n a l g o v e r n m e n t e x p e n d i tu r e s,

and i t cou ld be a rgued tha t i t i s more r easonab le t o focus on r ea l government

expe ndi tures , i .e .

G i (1 - I . t ) G i

g i = p i W i ( 2 0 )

Us ing (8) , (11) and (14) , i t turns out that

, 1 o /g ' ( 1 ) 1 - 1 + > 0 . ( 21 )O G i - - : - 2 n ] p i x i ]

S o i f t he government want s t o i nc rease r ea l government expendi tu res , i t can

a lway s ach i eve t h is by i nc reas ing nom ina l expendi tu res .

10 I n a s t a n d a r d a d - h o c m a c r o m o d e l , B r a n s o n a n d R o t e m b e r g ( 1 9 8 0 ) a l s o f i n d t h i s n e g a t i v ee x t e r n a l it y o f f i s c a l e x p a n s i o n i n t h e p r e s e n c e o f r e a l w a g e r i g id i t y .



36 T.M. Andersen, J.R. Scre nsen European Journ al of Political Econom y 11 (1995) 27-4 3

The ma in conc lus ion o f t h i s s ec t ion i s t ha t , i n a mone ta ry un ion , i t w i l l be

p o s s i b l e b y d e m a n d m a n a g e m e n t p o l i c i e s t o i n c r e a s e e m p l o y m e n t i n o n e c o u n t r y

bu t a t t he cos t o f l o s t employmen t i n t he o the r coun t r i e s . The re fo re , i f gove rn -m e n t s a r e c o n c e r n e d a b o u t u n e m p l o y m e n t , u n c o o r d i n a t e d f is c a l p o l i c ie s t e n d t o b e

too expans iona ry . In o the r words , i t w i l l be impor t an t t o coo rd ina t e even ba l anced

budge t f i s ca l po l i c i e s .

4. Optimal fiscal policy

Al thou gh d em and m anag em en t po l i c i e s a r e e f f ec t ive , i t is no t neces sa r i l y t he

case t ha t t he re is a we l f a r e case fo r pu r su ing such po l i c i e s. Ra the r t han ju s t t ak ing

t h e a im o f b o o s t i n g e m p l o y m e n t f o r g ra n t e d , w e s h a ll e v a l u a t e p o l i c y i n te r v e n t io nin t e rms o f i t s consequences fo r t he u t i l i t y o f a r ep resen ta t i ve consumer .

W e wi l l a s sume tha t t he gov e rnm en t in coun t ry i i s u ti l it a r ian and , by

summar i z ing the i nd i r ec t u t i l i t y func t ions ( i . e . ( 5 ) ) ove r a l l consumers i n coun t ry

i , t h e s o c ia l w e l f a r e f u n c t i o n b e c o m e s

M o / n + p i x i _ G iS W i = P - d N i + H f ( g i ) . ( 2 2 )

4 .1 . U n c o o r d i n a t e d fi s c a l p o l i c y

F r o m ( 2 2 ) w e f i n d t h a t a c h a n g e i n g o v e r n m e n t d e m a n d a f f e c t s s o c i a l w e l f a r e

th rough f ive d i f f e r en t channe l s s ince

Og I n i )g ' Og i p bg i ~)gi

+ H f ' ( g i ) ( 2 3 )

The f i ve channe l s a r e : ( i ) a r ea l ba l ance e f f ec t , ( ii ) a t e rms o f t r ade -e f f ec t , (i i i) an

ac t iv i t y e f f ec t , ( i v ) a cos t o f r a i s ing pub l i c r evenue e f f ec t , and (v ) a pub l i c

c o n s u m p t i o n e f f e c t.

I t is imp or t an t t o no t e t ha t t he ac t i v i t y e f f ec t a ri s e s due to t he d i s to r t i ons caused

by imper fec t compe t i t i on . In a s i t ua t ion wi th unemploymen t , t he soc i a l va lue o f

inc reas ing p roduc t ion i s t he marg ina l p roduc t o f l abour t imes t he t e rms o f t r ade

( p i / p = 1 in a symmet r i c equ i l i b r ium) wh i l e t he cos t i s t he d i su t i l i t y o f work

(d < 1) . I t shou ld a l so be no ted tha t t he r ea l ba l ance and r even ue e f f ec t s a r e

nega t ive , wh i l e t he t e rms o f t r ade , t he pub l i c consumpt ion and the ac t i v i t y e f f ec t s

are pos i t ive .

T o p r o c e e d , w e t e r m m i n u s t h e s u m o f t h e f i r s t f o u r e f f e c t s i n ( 2 3 ) ' t h e

m a r g i n a l c o s t o f u n c o o r d i n a t e d f i s c a l p o l i c y ' ( M C ~ , , ) and the l a s t e f f ec t ' t he

m a r g i n a l b e n e f i t ' ( M B i ) o f p u b l i c c o n s u m p t i o n . T h e n , a f t e r s o m e s t ra i g h t fo r w a r d



T.M. Andersen, J.R. Sorensen European Journal of Political Economy 11 (1995) 27-43 3 7

c a l c u l a t io n s , w e f i n d t h a t, i n a s y m m e t r i c e q u i l i b r i u m ( i. e. g i i s i d e n t i c al i n a ll

c o u n t r i e s ) , t h e m a r g i n a l c o s t i s 1 1

11( )e l - N , ,cn

M C ° = ( 2 4 11

_ _ _ g iN ,, - l g i 2 n

S i n c e g o v e r n m e n t c o n s u m p t i o n c a n n o t e x c e e d e m p l o y m e n t i n s e c t o r i ( i. e.

g i < N B ) , i t f o l l o w s t h a t M C i n i s a l w a y s p o s i t i v e .

I t i s w o r t h p o i n t i n g o u t t h at t he m a r g i n a l c o s t s o f e x p a n d i n g p u b l i c c o n s u m p -

t i o n a re d e c r e a s i n g i n t h e r e s e r v a t i o n w a g e o f t h e u n i o n ( 0 ) . T h i s f o l l o w s s i n c e

O M C ~ ,- - > 00 N , ,

a n d

0 N , ,- - < 0 .

8 0

T h e i n t u i t io n i s t h a t th e h i g h e r t h e r e s e r v a t i o n w a g e o f t h e u n io n , t h e h i g h e r t h e

w a g e , t h e lo w e r e m p l o y m e n t , a n d t h u s t h e la r g e r t h e in c e n t i v e o f t h e g o v e r n m e n t

t o u s e b a l a n c e d b u d g e t d e m a n d m a n a g e m e n t p o l ic i e s t o b o o s t a c t iv i ty .

T o e v a l u a t e M C ~ u . m o r e p r e c i s e l y , w e c o n s i d e r t h e s p e c i a l c a s e s w h e r e n = 1

a n d n - -* oo. I f n = 1 , t he n

1i

M C u n ( n = 1 ) = -c

a n d i f n ~ ~ , t h e n

M C i ~ M C i . ( n = ~ ) = - -

( 2 5 )

a U , ,1 iU,,-~g

( 2 6 )

I t i s e a s i l y s e e n t h a t M C ~ n ( n = ~ ) i s i n c r e a s i n g i n gi, a n d t h e t w o M C u n c u r v e s

a r e d r a w n i n F i g . 1 . M o r e o v e r , f r o m ( 2 4 ) i t f o l l o w s t h a t ( g i < N B )

O M C ~ ,< O . ( 2 7 )

8 n

11 W e h a v e a s s u m e d th a t t h e r e i s a n a s y m m e t r y b e t w e e n t h e b e h a v i o u r o f l a b o u r u n i o n s ( a n d f i r m s )

a n d g o v e r n m e n t s . T h e l a b o u r u n i o n s t a k e th e g e n e r a l p r ic e l e v e l a s g i v e n , w h e r e a s t h e g o v e r n m e n t s

t a k e i n t o a c c o u n t h o w t h e f i s c a l p o l i c y a f f e c t s t h e g e n e r a l p r i c e l e v e l. T h i s i s b e c a u s e t h e a s s u m p t i o n o f

o n l y o n e s e c t o r i n e a c h c o u n t r y i s j u s t a c o n v e n i e n t n o r m a l i z a t i o n o f a n e c o n o m y w i t h a l o t o f s e c t o r s ,

a n d w i t h a l a b o u r u n i o n i n e a c h s e c t o r . T h e r e f o r e , e a c h s e c t o r i s s u f f i c i e n t l y s m a l l t h a t t h e u n i o n c a n

i g n o r e t h e e f f e c t o n t h e g e n e r a l p r i c e l e v e l, b u t t h e r e i s o n l y o n e g o v e r n m e n t i n e a c h c o u n t r y , a n d i t

c a n n o t i g n o r e h o w i t a f f e c t s t h e g e n e r a l p r i c e l e v e l .



3 8 T.M. Andersen, J.R. SCrensen European Journal of Political Economy 11 (1995) 27 -4 3

M B 1 , M C

1

± d2

i . M C t m ( n = 1 )

, , ~ M B t

Fi g . 1 .

Thi s i s so becau se t he m ore coun t r i e s, t he h igher i s the em ploym ent e f fec t and the

t e rms o f t r ade e f f ec t o f i nc reas ing government expendi tu res . I t f o l l ows tha t , f o r

1 < n < 0% the M C i n curve i s be tween i _ _C u . ( n - 1) and M C i n ( n = ~ ).

In F ig . 1 , we have a l so d raw n the m arg ina l benef i t cu rve :

m o i = H f ¢ ( g i ) . ( 2 8 )

^ iAn in t erna l soc ia l op t imum (gun) r equ ir es

M B i = MC~ m. ( 2 9 )

A l t h o u g h M c i . i s not necessar i ly increas ing in g i , i t i s m onoton e i n g i . U s ingthat i iM C ~ ( n = o o ) < M C i n < M C u n(n = 1) , i t can be shown that there exis t s a

unique socia l opt imum 12, and

g in(n = 1 ) ~< ^ i ^ i = ~ ) . ( 3 0 )"~- g u n ~ g u n ( n

Moreover , us ing (27) , i t fol lows that

^ iOgun- - > O . ( 3 1 )

On

The more coun t r i e s , t he l ower i s t he marg ina l cos t o f i nc reas ing government

expen di tures , and therefore ^~un increases.

12 A s u f f i c i e n t c o n d i t io n f o r t h e e x i s t e n c e o f a n i n t e r n a l s o c i a l o p t i m u m i s t h a t M B i ( g i = N B ) <

M C ~ ( g i = NB ) o r d > Hf ' ( N B ) . I n o t h e r w o r d s , t h e m a r g i n a l b e n e f it o f g o v e r n m e n t c o n s u m p t i o n ,

w h e n a l l w o r k e r s p r o d u c e f o r t h e p u b l i c s e c t o r m u s t b e l o w e r t h a n t h e m a r g i n a l d i s u t il i ty o f w o r k .

U n i q u e n e s s f o ll o w s f r o m t h e f a c t t h at M C i s c o n v e x a n d b y u s e o f t h e s e c o n d - o r d e r c o n d i ti o n t h a t

a MB i / Og i < I ~ MC ~ l o g i.



T.M. Andersen, J .R. SOrensen European Journal of Poli t ical Econom y 11 (1995) 27 -43 39

4 .2 . C o o r d i n a t e d f i s c a l p o l i c y

S i n c e we h a v e i d e n t i c a l c o u n t r i e s , i t i s mo s t r e a s o n a b l e t o c o n s i d e r t h e c a s ewh e r e c o o r d i n a t e d f i s c a l p o l i c i e s a r e s y mme t r i c . T h e r e f o r e , t h e ma r g i n a l c o s t o f

c o o r d i n a t e d f i s c a l p o l i c y i s

1M c ; = + = - ( 3 2 )

n Og i ~ c

a n d we n o t e t h a t t h e r e i s n o t e r ms o f t r a d e a n d a c t i v i t y e f f e c t s i n t h i s c a s e .

W e s e e t h a t M C ~ - i _M C u n ( n - 1) , and s ince M B ~ i s i n d ep e n d e n t o f w h e t h e r

t h e r e i s c o o r d i n a t i o n o r n o t , i t f o l l o ws f r o m F i g . 1 t h a t

g~o i • gn~ i f o r n > 1 . (33 )

I n o t h e r wo r d s , we s e e t h a t u n c o o r d i n a t e d f i s c a l p o l i c y i s mo r e e x p a n s i o n a r y t h a n

c o o r d i n a t e d f i s c a l p o l i c y . T h e r e a s o n f o r t h i s i s t h a t t h e t wo p o s i t i v e we l f a r e g a i n s

a g o v e r n m e n t p e r c e i v e s t o b e a b l e to r e a p b y a n e x p a n s i o n o f d e m a n d , n a m e l y , th e

i m p r o v e m e n t i n t e r m s o f t r a d e a n d t h e e x p a n s i o n o f e m p l o y m e n t , d o n o t a r i s e

wh e n p o l i c i e s a r e c o o r d i n a t e d .

T h e d i f f e r e n c e b e t w e e n t h e n a t i o n a l i n c e n t i v e s a n d E M U - w i d e i n c e n t i v e s t o

c h a n g e g o v e r n m e n t d e m a n d i s m a d e u p o f t h e t e r m s o f tr a d e e f f e c t a n d t h e a c t iv i ty

e f f e c t . T h e t e r ms o f t r a d e - e f f e c t h a s b e e n wi d e l y d i s c u s s e d i n t h e l i t e r a t u r e o n

f i s c a l p o l i c y c o o r d i n a t i o n ( s e e e . g . T u r n o v s k y , 1 9 8 8 ; De v e r e u x , 1 9 9 1 ) . T h e s e c o n dc h a n n e l a r i s i n g t h r o u g h t h e a c t i v i t y e f f e c t d o e s n o t a r i s e i n t h o s e mo d e l s a s t h e y

a r e b a s e d o n p e r f e c t c o mp e t i t i o n a n d f u l l e mp l o y me n t . 1 3 I n t h e p r e s e n t s e t t i n g o f

i mp e r f e c t c o mp e t i t i o n , i t a r i s e s b e c a u s e t h e d i s t o r t i o n s i mp l i e d b y i mp e r f e c t

c o mp e t i t i o n c a u s e a c t i v i t y t o b e i n o p t i ma l l y l o w f r o m a s o c i a l p o i n t o f v i e w , a n d

h e n c e t h e r e a r e g a i n s f r o m e x p a n d i n g a c t i v i t y .

W e l f a r e i m p l i c a t i o n s o f c o o r d i n a t i o n

I n a s y m m e t r i c e q u i li b r iu m t h e tr u e m a r g i n a l c o s t o f g o v e r n m e n t c o n s u m p t i o n

is M C ~ o , a n d h e n c e s o c i a l w e l f a r e d u e t o g o v e r n m e n t c o n s u m p t i o n ( S W G i )b e c o m e s th e a r e a b e l o w t h e M B i c u r v e m i n u s t h e a r e a b e l o w t h e M C i = M C i o ( n

= 1) curve, i .e .

1S W G i = H f ( g i ) _ _ g i ( 3 4 )

c

a n d i t i s e a s i l y s e e n t h a t t h e o p t i m a l g o v e r n m e n t c o n s u m p t i o n i n a s y m m e t r i c

13 This is not the ca se in the Barro and G ordon typ e of m odels (see e.g. C anzoneri and Henderson

(1991) and B ryson et al. (1993)). But they build on the existence of nominal wa ge contracts, and it isjust assum ed in an ad hoc way th at governmentsprefer full employment.



40 T.M. Andersen, J .R. Serensen ~Europ ean Jou rnal o f Poli t ical Econom y 11 (1995) 27 -43

eq uil ib rium is g¢o^i (w he re n f ' ( g i ) = 1//c). T he los s i n soc i a l w e l f a re due to

uncoord ina t ed f i s ca l po l i cy i s t he re fo re

1 1^ i ^ ii ^ i ^ i _ _ ^ i _ _ n f ( g u n ) . . ~ _ -L = S W G i ( ~ i ) - S W G ( g u n ) = H f ( g c o ) - c g e o c g u n •

(35)

I f w e c o n s i d e r h o w t h is l o s s d e p e n d s o n t h e n u m b e r o f c o u n t ri e s in t h e u n i o n , w e

f ind tha t

a n - M B ( g u n ) + --~n--n 0. (3 6)

B y use o f (32) and tha t i ^ iB (gun) < 1 / / c , i t f o l low s tha t t h i s expres s ion i s

pos i t i ve . H ence , t he los s f rom no t coo rd ina t ing the f i s ca l po l i cy i s i nc reas ing in then u m b e r o f c o u n t r i e s in t h e m o n e t a r y u n i o n .

O n the o the r hand ^ i¢o i s no t a N ash equ i l ib r ium , so the pa r t i c ipa t ing coun t r i e s

a re t em pted to inc rease g i . T h e t em p ta t ion fo r a m arg ina l i nc rease in g i above g~o

i s g iven a s

_ _ i i iT - M B ( g . ) - M C i n ( g c o )

1= - - - M C i n ( g c o ) > 0 ( 3 7 )

c

w h i c h i s p o s i t i v e b e c a u s e M C i < M C ~ o = 1 / c . M oreover , u s ing (27) , i t f o l low s

that

a T- - > 0 ( 3 8 )~n

so the t em p ta t ion to dev ia t e f rom g~o is i nc reas ing in the num ber o f coun t r i e s .

W e m ay co nc lud e tha t i t i s m ore im p or t an t t o coord ina t e f is ca l po l i cy in a l a rge

than in a sm a l l m on e ta ry un ion ( s ince L i s inc reas ing in n ) , bu t i t a l so seem s to be

m o re d i f f i cu l t t o im plem ent t he coord in a t ed fi s ca l po l i cy ( s ince T i s inc reas ing in

n ) . 1 4 U nder the r easonab le a s sum pt ion tha t t he re a re cos t s a s soc ia t ed w i th

coord ina t ing po l i c i e s , t h i s sugges t s t ha t t he re i s an op t im a l s i ze o f an E conom ic

a n d M o n e t a r y U n i o n .

5 . C o n c l u s i o n

Im por t an t po l i cy conc lus ions em ana t ing f rom th i s ana lys i s a r e t ha t ba l anced

b u d g e t d e m a n d m a n a g e m e n t p o l i c ie s a re e f f e c t i v e m e a n s t o i n c re a s e e m p l o y m e n t ,

14 In a mult iperiod model with repeated games this is not necessarily the case, since the cos t of

deviating from the coordinated fiscal policy may be a future loss from ending up in the Nash

equilibrium with uncoordinated fiscal policies - and as seen above this cost is increasing in n. For

examples of repeated games in international policy coordination, see e.g. Canzoneri and Henderson

(1991) and Chang (1990).



T.M. Andersen, J.R. SCrensen European Journal of Political Economy 11 (1995) 27-43 41

but t h ey i nvo lve a b eggar - thy-ne ighb our ex t e rna l i ty . Th i s imp l i e s tha t f i s ca l po l i cy

needs t o be coord ina t ed t o avo id i ne f fi c i enc i es caused by a t t empt s to im prove

t e rms o f tr ade and bo os t ac t i v i ty .Imp os ing t he r equ i r ement o f ba l anced budge t s i s obv ious ly a s t ronger cons t ra in t

t h a n th e b u d g e t n o r m s p r o p o s e d f o r a E u r o p e a n E c o n o m i c a n d M o n e t a r y U n io n .

The as sumpt ion se rves t he purpose o f s t r e s s ing t ha t t he need fo r coord ina t ion o f

f i sca l po l i cy i n a m one ta ry un ion i s no t conf ined to t he p rob l em of pub l i c budge t s .

A l l o w i n g f o r b u d g e t i m b a l a n c e s m a y l e a d g o v e r n m e n t s t o p u r s u e e v e n m o r e

expans ion ary po l ic i e s s ince t he n eed to ba l ance t he bu dge t an d the a s soc i a t ed cos t

wi l l f i r s t a r i s e i n t he fu tu re . There fore , budge t a ry norms a re no t su f f i c i en t t o

depr ive dem and m anag em ent po l i c ie s f rom ine f f ic i enc i es ca l l ing fo r i n t e rven t ion .

T h e p h i lo s o p h y u n d e r l y i n g t h e d e b a te o n t h e E u r o p e a n E c o n o m i c a n d M o n e t a r y

Un ion has so f a r been tha t t he ad jus tment o f f i s ca l po l i cy shou ld be l e f t to m arke tfo rces p resuppos ing t ha t t h is wou ld b r ing abou t a co nvergence o f tax r a t e s t ak ing

in to account t he mobi l i t y o f t he t ax bases . I t has been po in t ed ou t t ha t t h i s may

lead to inef f ic ient 'compet i t ion ' in tax ra tes ( see S inn, 1990) . The present analys is

shows tha t i t may a l so l ead t o i ne f f i c i en t ' compe t i t i on ' t o expand pub l i c demand .

The p resen t ana lys i s po in t s t o t he need o f supp lement ing budge t a ry norms wi th

l imi ta t ions on the s ize of the publ ic sector . This need i s larger the larger the

number o f coun t r i e s pa r t i c ipa t i ng i n t he un ion . Hence , t he re seems to be a

t r a d e - o f f b e t w e e n a u t o n o m y i n f i sc a l p o li c y a n d t h e s iz e o f a n E c o n o m i c a n d

M o n e t a r y U n i on .

Is i t p laus ible that f i scal pol ic ies tend to be too expansionary? Current ly , the

oppos i t e seems to be t he p rob l em. I t shou ld , however , be no t ed t ha t t he r e su l t

r epor t ed he re r e f e r s t o a s i t ua t i on wi th f i xed exchang e r a t e s e l imina t ing mo ne ta ry

res tr a in ts on t he use o f f i s ca l ins t rument s . Mo reover , i t shou ld be po in t ed ou t t ha t

a l though uncoordinated f i scal pol ic ies are too expansionary, i t i s s t i l l the case that

une m ploy me nt i s t oo h igh . Hence , t he re is a need to boo s t ac t iv i t y , bu t de ma nd

swi t ch ing po l i c ie s a r e no t t he r i gh t ins t rument . A l though the a s sumpt ions under ly -

ing t he an a lys i s do n o t m a tch cur r en t cond i t i ons , i t is wor th p o in t i ng ou t t ha t t he

mo de l i s no t w i thou t r e l evance fo r cur r en t po l i cy p rob lems . F i r st , t he a t temp t s by

m e m b e r - st a te s o f t h e E u r o p e a n C o m m u n i t y to f i n d w a y s t o r e s e rv e p u b l i c d e m a n d

for domes t i c p roducer s r e f l ec t exac t ly t he i ncen t ives under ly ing t he p resen t

ana lys i s . S econdly , t he demand- swi t ch ing e f f ec t s o f f i s ca l po l i cy have mot iva t ed

dem and ma nag em ent po l i c ie s i n e. g . t he Nord i c coun t r ie s in t he 197 0 ' s and 8 0 ' s

(Andersen, 1990) .

W e h a v e a s s u m e d t h a t t h e f i n a n c i n g o f p u b l i c d e m a n d w a s a c h i e v e d b y

lump -sum t axes . Obv ious ly th i s is a spec i a l a s sump t ion wh ich has p rec luded f rom

the ana lys i s t he d i s to r t i ons impl i ed by more r ea l i s t i c fo rms o f t axa t ion ( see e . g .

An ders en e t a l ., 1993; V an d er P loeg, 1987) . I t is obvious that i f pub l ic

expendi tu re mus t be f i nanced by d i s to r t i ona ry t axes , a f i s ca l expans ion becomes

l es s a t t r ac t i ve . On the o the r hand , i t does no t change t he f ac t t ha t demand

management po l i c i e s i nvo lve a beggar - thy-ne ighbour e l ement , and , t he re fore ,



42 T.M. Andersen, J.R. Scrensen /European Journal of Political Economy 11 (1995) 27-43

uncoordinated f iscal po licy tends to be too expansionary. M oreov er , the beggar-

thy-neigh bou r eleme nt will s til l be increasing in the num ber o f countries imp lying

that the problem s caused by uncoordinated f iscal policies will s til l be increasing inthe num ber of participating countries.

Concerning the welfare gain from cooperation, i t should be noted that we have

ignored po ssib le administrative co sts from coordinating fiscal po licies In practice

such costs could be quite important, and will probab ly depend o n factors like the

political and institutional systems in the member countr ies, the size of the public

sectors, etc. N eed les to say, taking s uch costs into consideration cou ld change o ur

conclusion that welfare is always highest when policies are coordinated.

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Economics Letters 24, 279-285.

andersen unemployment

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