Together We Are Strong—Divided Still Stronger? Strategic Aspects of a Fiscal Union

Abstract

In this paper we present an application of dynamic tracking games to a monetary union. We use a small stylized nonlinear two-country macroeconomic model of a monetary union for analysing the interactions between two fiscal (governments) and one monetary (common central bank) policy makers. We introduce a negative asymmetric demand side shock describing the macroeconomic dynamics within a monetary union similar to the economic crisis (2007–2010) and the sovereign debt crisis (since 2010) in Europe. We investigate the welfare consequences of three scenarios: fiscal policies by independent governments (the present situation), centralized fiscal policy (a fiscal union) with an independent central bank, and a fully centralized fiscal and monetary union. For the latter two scenarios, we investigate the effects of different assumptions about the weights for the two governments in the cooperative agreement.