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This paper explores the fiscal devaluation hypothesis in a model of
a monetary union characterised by national fiscal policies and
supranational monetary policy. We show that a unilateral tax shift
towards indirect taxes in one of the countries produces small but
non-negligible long run effects on output and consumption within
and between the two countries only when international financial
markets are perfectly integrated. In contrast to the existing
literature, we find that short-run effects are not always amplified
by nominal wage rigidities. We document also how short-run effects
of the tax shift depend on the choice of the inflation index
stabilized by the central bank and on whether the tax shift is
anticipated.
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