Abstract:
This paper constructs a two-region New Keynesian model with sticky prices and wages to study the optimal fiscal transfer rule in regions of a country. This paper finds that the optimal transfer rule should eliminate the output gap difference of regions. Welfare analysis shows that fiscal transfer improves the welfare of country, and welfare gain increases with regional home bias increasing. The optimal rule is better than that targeting difference in consumption gap, price inflation, wage inflation, and government spending. This paper also compares the welfares of debt aid and fiscal transfer. When the aid receiver repays partial debt and interest, the effect of debt aid is same as that of fiscal transfer; when the interest rate of debt is higher than risk-free interest rate, the welfare of debt aid is less than that of fiscal transfer.
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