Search

This paper analyzes in detail the mechanisms behind fiscal stabilization policy and the role of policy commitment in a micro-founded New-Keynesian model of a two-country monetary union, which is hit by supply shocks. We also explore the determinants of the gains from fiscal stabilization. While monetary policy with identical union members is concerned with stabilizing the union-wide economy, fiscal policy aims at stabilizing inflation differences and the terms of trade. Besides exploring optimal policies, we also consider monetary and fiscal rules. We study these rules both under coordination and non-coordination by the fiscal authorities. Keywords: Optimal monetary and fiscal policies; Rules; Commitment; Discretion; Monetary union JEL classification: E52; E61; E62; E63; F33

We show how a stability pact based on deficit sanctions eliminates the exacerbation of debt accumulation that may arise from monetary unification. Moreover, with sanctions contingent on the observed state of the economy, the pact avoids aggravating the situation of a country in recession. Moral hazard problems arise if the state also depends on unobservable, politically costly fiscal effort. This could explain why sanctions under the actual Stability and Growth Pact are only automatically waived in extreme recessions and why the procedure linking observed deficits and sanctions involves a long and detailed assessment of a country's situation. Keywords: Stability pact; Monetary union; Public debt; Contingent deficit sanctions; Fiscal effort JEL classification: E42; E61; F33

With benevolent policymakers and fiscal leadership, monetary unification reduces inflation, taxes and public spending. These disciplining effects of a monetary union, which become stronger if the number of participants in the union increases, are likely to raise welfare. Two types of arrangements are considered for the union's common central bank (CCB): making the CCB more conservative and imposing an inflation target on the CCB. In contrast to the results of Svensson (1997) [Svensson, L.E.O., 1997. Optimal inflation targets, 'conservative' central banks, and linear inflation contracts. American Economic Review 87, 98-114], an optimally designed, conservative CCB may outperform inflation targeting. Finally, we find that fiscal coordination offsets the disciplining effects of monetary unification. Hence, subsidiarity in fiscal policymaking may enhance welfare. Keywords: Monetary union; Fiscal leadership; Common central bank; Discipline; Central bank conservatism; Inflation (targets); Optimal institutions; Fiscal coordination