exports are depressed and imports rise. Employment gains are relatively small and fade away
slowly in the years following the immediate expansion.
The positive short run output effects are much less pronounced in countries like Ireland,
Belgium and the Netherlands, where the high degree of openness means that a much larger
share of the fiscal impulse leaks abroad via higher imports9. In these small open economies
the price level rises less than in the other countries, as the share of imports is much higher.
With a smaller inflationary response to the fiscal expansion there is a smaller reduction in
real short interest rates and the impact multiplier is accordingly smaller or even negligible.
6SLOORYHUV
The extent to which fiscal policy actions of a country affect its trading partners depends
crucially on the exchange rate regime and the monetary regime in the country undertaking
fiscal action. Under fully flexible exchange rates the spillovers are small. A fiscal expansion
in one country will be accompanied by a monetary expansion and higher prices. There may
be a small depreciation of the exchange rate, but in real terms there will be an appreciation of
the effective exchange rate as domestic prices rise faster than foreign prices. The boost to
other countries from higher export demand will however be partially offset by higher real
interest rates, which depresses domestic demand. Because these two effects go in opposite
directions, the total spillover effect is likely to be small.
Under fixed exchange rates and monetary targeting spillovers can become negative when a
fiscal expansion leads to higher interest rates abroad. Assume, for instance, an ERM-type
scenario in which all European countries fix their exchange rates vis-à-vis the DM and follow
the German interest rate policy. If the German authorities adhere to a strict money targeting
regime, a German fiscal expansion has only small expansionary effects in Germany as
German interest rates are raised instantaneously. Due to this monetary tightening the German
exchange rate will appreciate relative to the dollar. But this will lead to an increase in interest
rates all over Europe, as the other European countries must follow with a monetary
contraction to keep exchange rates in the ERM fixed. The dampening effect of the higher
interest rates on domestic demand more than offsets the positive effect of higher demand for
exports, which are small anyway under money targeting, and the net effect on GDP in the
other European countries will be largely negative. Obviously, such negative spillovers will
be mitigated under EMU when interest rates are set by a European central bank, which
targets total money supplies in the EU. Then a German fiscal expansion will lead to a much
smaller increase in interest rates as its effect on total EU money demand is significantly
smaller. Consequently, the negative spillover to other European countries will be
considerably smaller, also because the smaller increase in German interest rates will allow a
larger domestic expansion and higher demand for other countries’ exports.
Table 9 below summarises the spillover effects of a fiscal expansion in Germany under
flexible and fixed exchange rates and under alternative monetary assumptions. The first three
rows in the table relate to an accommodating monetary policy with, respectively, national,
German and EU monetary authorities targeting nominal interest rates. A fiscal expansion in
Germany raises export demand and boosts growth in all other European countries. These
spillover effects lead to higher growth in those countries that have a relatively large degree of
9 A crucial assumption here is that the same share of the government purchases of goods and services
is imported from abroad as for other domestic demand components. The impact multiplier would be
higher if a domestic bias is assumed for government purchases.
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