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Fiscal Unions with Present Biased Governments
This paper studies the relationship between fiscal rules and intergovernmental transfers within a federation. We analyze an environment where present-biased governments must insure against future shocks. The present bias generates a reason for fiscal rules to exist, while risk sharing motives bring out the need for transfers. A central authority designs the optimal combination of state contingent transfers and fiscal rules that maximize the federation‘s welfare. We show that independently of the present bias, it is optimal to achieve the first-best pattern of aggregate spending. However, how it is implemented depends on the intensity of the bias. When the bias is mild, a mechanism akin to an emergency fund with tight fiscal rules arises, while when the bias is severe, it is optimal to provide loans with contingent payments and to loosen up fiscal rules. Moreover, there is always a degree of bias for which a fiscal union is not optimal.
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