“Set a Sufficiently Ambitious Budget Target and Let the Automatic Stabilizers Work”. Will it Really Work in the European Monetary Union?

We examine the popular recipe in the title by means of an AD-LM-AS two-country model of the EMU, controlling for asymmetry in demand and supply shocks and in the monetary-policy transmission mechanism. Unless structural symmetry holds and symmetric shock occurs, national automatic stabilizers, even though supplemented with the common monetary policy, cannot deliver optimal stabilization in each economy. Inflation and output gaps are not closed and may be divergent in sign. Considering that a federal system of inter-regional insurance is lacking, the recipe under examination is too optimistic, while serious threat to EMU cohesion may arise. The econometric estimates we present show that existing national fiscal systems work very poorly as for the minimization, after shocks, of the dispersion of national incomes around the EMU average.