Potential Output and Fiscal Rules in a Monetary Union Under Asymmetric Information

Abstract

We analyze fiscal rules within a Monetary Union in the presence of (i) asymmetric information on member states’ potential output and (ii) bail-out among member states. The first-best deficit is contingent on the cycle, that is, on member states’ output gap. In the presence of asymmetric information and bailout, the first-best deficit is not implementable. Bail-out lowers the scope for signalling (discrimination) by member states (lenders) and induces overborrowing by member states characterized by a low output gap. The Monetary Union can design a mechanism such that a member state with a smaller negative output gap runs an optimal budget deficit upon receiving a transfer form the Union. We show that, this ‘cyclically-contingent’ fiscal framework Pareto dominates the ‘cyclically-adjusted’ fiscal rule currently enforced by the European Monetary Union. Our model can then account for a situation where both asymmetric information over cyclical positions and the presence of bail-out among member states does not induce borrowing distortions.