Fiscal deficits as a source of boom and bust under a common currency

•A theoretical model of a small open economy under a common currency is constructed.•It has New Keynesian features of staggered price setting and overlapping generations.•A one-period debt-financed tax cut (permanent government debt increase) is studied.•The resulting initial boom (positive output gap) is inevitably followed by a bust.•This differs from the monotonic convergence which normally follows a demand stimulus. We investigate in depth, using predominantly analytical rather than numerical methods, the mechanisms triggered by a one-off debt-financed fiscal deficit in a small open economy with a shared currency. The economy incorporates staggered price setting and overlapping generations. Unsurprisingly, these cause the impact effect to be a boom, in the sense of price inflation and a positive output gap. However, contrary to what normally happens in New Keynesian models without extraneous dynamics, the boom later inevitably turns into a bust, i.e. price deflation and a negative output gap. Therefore, in this setting, while short-run Keynesian deficit-based fiscal stimulus ‘works’, it also provokes a medium-run ‘backlash’ in aggregate activity.