Academic journal article The European Journal of Comparative Economics

European Economic Policies at Work: The Costs of Price Stability and Budget Consolidation

Academic journal article The European Journal of Comparative Economics

European Economic Policies at Work: The Costs of Price Stability and Budget Consolidation

Article excerpt


The paper investigates whether the policy framework adopted by the EMU participating countries might create recessive tendencies. First we check the existence of a deflationary bias by separately analysing monetary and fiscal policy. The analysis of monetary policy focuses on a backward- and a forward-looking monetary rule. The reaction functions are estimated to capture the criteria that a centralized monetary authority should use in setting short-term interest rate. Second, a comparative analysis is made of the ability of different central banks to stabilize output and inflation. Precisely, we compare the strategy followed by the European Central Bank, the Deutsche Bundesbank and the US Federal Reserve. Then, a measure of fiscal bias is retrieved by estimating the impact that a change in the primary surplus to GDP ratio has on the real economy. Finally, we search for a quantitative assessment of the recessive propensity of the European economic policies by estimating an overall policy bias. The results suggest the EU institutional set-up might create and/or amplify the recessive tendencies. The policy constraints the EMU members face were dreamt when the Community was struggling with an inflationary legacy. The danger nowadays is not inflation but rather its opposite, deflation. As a consequence, the EU institutions need to be at least partially reformed.

JEL Classification: C52, E52

Keywords: Monetary and Fiscal Strategy, ECB, EMU

1. Introduction

This paper deals with the characteristics of the economic policies pursued in European Monetary Union (henceforth EMU and with their theoretical fundamentals. The main interpretative hypothesis underlying the study is that a deflationary bias is embodied in the way the policy authorities act within the European framework.

This recessive propensity depends on the overall criteria concerning the institutional commitments on the conduct of both monetary and fiscal policies. More specifically, the commitment of price stability for the European Central Bank (ECB) together with the commitment of financial stability for the member state governments aims at achieving the minimum inflation rate without any matter to employment and production levels. We could define the European deflationary bias as a policy that, in conditions of neutrality, transmits recessive impulses to the economy.

The approach of overall European economic policies is founded on specific theoretical hypothesis that can be easily retraced in the ECB and European Commission documents. A clear distinction between the policy makers and the politicians, that are supposed to suffer of "inflationary bias"; the central role of monetary stability; the neutrality of monetary policy and hence the ineffectiveness of aggregate demand based policies; the destabilizing effects of high public deficit and debt according to the validity of "equivalence theorem".

We form the hypothesis that the deflationary bias is a legacy of the Maastricht Treaty, i.e. of the strong commitment to fiscal and monetary policies of candidates' countries. Hence, using a database that covers a period preceding the launch of euro, we try to check the potential deflationary bias of current policies.

The remainder of the paper proceeds as follows. Section 2 introduces the structural model used in the empirical analysis and presents the econometric methodology applied in order to evaluate the existence of a monetary policy deflationary bias. In particular, a backward- and a forward-looking monetary rule are estimated to capture the criteria used by European Central Bank to fix short term interest rate. An efficiency frontier analysis and a comparison of the results with the behaviour of Deutsche Bundesbank and Federal Reserve are also provided. In Section 3, a measure of fiscal bias is obtained by estimating the impact of primary surplus on European output gap. Section 4 concerns a quantitative evaluation of the recessive propensity of both monetary and fiscal policies. …

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