Real exchange rates, agglomerations, and irreversibilities: Macroeconomic policy and FDI in EMU

Fiscal policy in EMU has to be evaluated in the light of the changing nature of capital mobility in Europe and its effects on growth. Most arguments about the effects of fiscal policy in EMU assume that we live in a perfect competition world with a unique natural rate of output for each country. The removal of barriers to foreign direct investment (FDI) accompanied by the prevalence of imperfect competition mean that the natural rare of output is to be determined by locational competition. We show that FDI is influenced by relative costs and is attracted by agglomerations, and that the level of technology depends on the stock of FDI. Sustained expansionary fiscal policies will raise costs and make locations less attractive. Agglomerations could be destroyed by these higher costs, and the size of the nation will shrink. These effects will constrain policy-makers much more than the Stability Pact.