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Fiscal institutions and welfare in an open economy

This paper shows that, in a multi-country framework with government deficit spillovers, designing institutions that reduce the budget deficit is an optimal response from a country’s individual point of view. However, at an aggregate level this non-cooperative behavior is counterproductive. The case in which countries cooperate in the design of their fiscal institutions is also studied and compared with the former scenario. The study provides a new approach for analyzing mechanisms, such as the Stability Pact for Europe’s monetary union, recently implemented with the aim of reducing the budget deficit.