Public Deficits and Economic Growth

Within the discussion on how to implement fiscal discipline in the European Monetary Union, the adequacy of using the same fiscal rules for different MemberCountries has been challenged by some authors, calling for a temporary higher degree of fiscal flexibility in the case of small and less developed countries. We develop a model of a monetary union between two countries that may differ in (i) economic dimension; (ii) exogenous levels of productivity directly related with the quality of domestic institutions; (iii) technological knowledge stocks; (iv) Research and Development (R&D) capacity. By using comparative statics, the model allows us to examine the impact of fiscal shocks leading to public deficits and thus analyse (i) the eventual different implications of such deficits whether they occur in the small or in the big country; and (ii) whether an excessive deficit should (or not) be allowed in order to permit the catching up by the less developed country; (iii) whether some expenses related to public investment (incentives to R&D) should (or not) be considered as “pertinent” factors as considered in the recent SGP reform.