Independent or Coordinated? Monetary and Fiscal Policy in EMU

Abstract

AbstractWe examine the relations between monetary and fiscal policies in the con-text of a model which embodies relevant features of EMU. Our analysissuggests that, even in the absence of asymmetric shocks and of aggregatedemand spillovers, EC authorities and national governments may have con-flicting incentives, depending upon the relative size of demand and supplydisturbances. When both aggregate demand and supply shocks are positive(negative) and the latter are large enough in absolute terms, then nationalgovernments will pursue a more expansionary (contractionary) fiscal policythan it would be desirable from a social welfare standpoint.Our results imply that, if the EC authorities are required to enforce asocial welfare function defined over aggregate output and inflation, then itmay be necessary to endow the EC with appropriate enforcement deviceswith respect to the fiscal policy stance of individual member countries. Thisis true even if national governments do not have an incentive to adopt atime-inconsistent behavior. Hence our conclusions support the idea that thesetting of fiscal policies by member countries needs to be disciplined, and insome instances possibly over-ruled, by the EC authorities.JEL classification : E50, E61, E63, H30.Keywords: Monetary Policy, Fiscal Policy Rules, Policy Coordination,EMU, Stability and Growth Pact