Global shocks, budgets deficits, and international fiscal policy coordination

Abstract

A simple two-country model with trade, fiscal and interest rate externalities is used to study strategic interactions between national policymakers. Optimal fiscal policy internalizes a trade-off between output stability and fiscal stability. With lump-sum taxation, the noncooperative equilibrium is inefficient and both countries are better off under coordination. These results also hold if taxation is distortionary and trade generates a fiscal externality as well, regardless of how strong the preference for output stability is. In response to a negative global demand shock, consistent with the disruptions that occurred during the recent pandemic, the optimal policy response is to increase spending by more under cooperation. However, if budget deficits generate a sufficiently strong negative cross-border externality through higher interest rates, the optimal response calls for lower spending under cooperation.