Example: Fiscal Transfer
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Assume there is a negative demand shock in Portugal, but a positive demand shock in Spain (the shocks are asymmetric). Portugal experiences a rise in unemployment and a worsening of budgetary positions because of automatic stabilizers. Spain sees unemployment fall and an improvement in budgetary positions (again because of automatic stabilizers). Had Spain and Portugal paid taxes and received welfare from a central European authority, that authority could have transferred some of Spain’s fortune to Portugal. As it stands now, however, Portugal is left on its own. The worsening budgetary position makes is harder for the Portuguese government to conduct discretionary fiscal policy because of the restrictions on its budgetary position by the Stability and Growth Pact.