Monetary union without fiscal coordination may discipline policymakers

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