Fiscal Deficits as a Source of Boom and Bust under a Common Currency (joint with Giovanni Ganelli, IMF)

Abstract: We investigate in depth, using analytical rather than numerical methods, the mechanisms which operate following a one-period, debt-financed, fiscal deficit in a small open economy operating under a common currency. The economy incorporates the New Keynesian features of staggered price setting and overlapping generations. Unsurprisingly, these features cause the impact effect to be a boom, in the sense of a positive output gap. However we also find that the boom must later turn into a bust, or negative output gap. Moreover inflation also follows a boom-bust pattern. On average there is deflation rather than inflation.