Optimal discretionary monetary and fiscal policies in a country-size heterogeneous monetary union

Abstract

This paper develops a New Keynesian model of a monetary union where atomistic-small economies coexist with a large economy. It explores how the level of public debt shapes non-cooperative discretionary policies. It evaluates welfare losses for small and large member countries.The paper demonstrates that higher public debt levels hamper business cycle stabilization for the union as a whole and, in particular, penalize the stabilization performance of small country-members. While cooperation and monetary leadership is preferable to fiscal leadership for the union as whole and for the small countries, the big country prefers fiscal leadership, where it explores a larger strategic power vis-a-vis the common monetary policy authority. Political support for cooperation may be hard to achieve. Under low debt levels, cooperative stabilization outcomes are relatively similar to the non-cooperative ones.