Optimal Fiscal Policy Rules in a Monetary Union

By Kirsanova, Tatiana; Satchi, Mathan et al. | Journal of Money, Credit & Banking, October 2007 | Go to article overview

Optimal Fiscal Policy Rules in a Monetary Union


Kirsanova, Tatiana, Satchi, Mathan, Vines, David, Wren-Lewis, Simon, Journal of Money, Credit & Banking


This paper investigates the importance of fiscal policy in providing macroeconomic stabilization in a monetary union. We use a microfounded New Keynesian model of a monetary union, which incorporates persistence in inflation and non-Ricardian consumers, and derive optimal simple rules for fiscal authorities. We find that fiscal policy can play an important role in reacting to inflation, output, and the terms of trade, but that not much is lost if national fiscal policy is restricted to react, on the one hand, to national differences in inflation and, on the other hand, to either national differences in output or changes in the terms of trade. However, welfare is reduced if national fiscal policy responds only to output, ignoring inflation.

JEL codes: E52, E61, E63, F41

Keywords: optimal monetary and fiscal policies, monetary union, simple rules.

IN THIS PAPER, we show how national fiscal policy can help to stabilize individual economies within a monetary union. While the vulnerability of monetary unions to asymmetric shocks is well known, there has been little analysis of the extent to which fiscal policy can overcome these problems within the framework of the new international macroeconomics (see Lane 2001, Ganelli and Lane 2003 for a survey of this literature). This is despite the fact that policy makers in potential members of the European Monetary Union (EMU) have actively discussed the possibility of using fiscal policy in this way (Swedish Committee 2002, Treasury 2003).

Since the work of Mundell (1961) and the subsequent Optimum Currency Area literature, it has been recognized that members of a monetary union would be vulnerable to asymmetric shocks. It has also been recognized that union members could in principle reduce this vulnerability by using fiscal policy in a countercyclical manner. While earlier studies have suggested that fiscal policy could be effective in this role (see, e.g., Hughes Hallett and Vines 1991, Driver and Wren-Lewis 1999), they have tended to use models without explicit microfoundations. The value of clear microfoundations when analyzing fiscal policy is apparent: it is important to consider the impact of fiscal actions on agents' lifetime income, on labor supply as well as consumption, and on the solvency of the government. We can use a setup with these features to conduct a rigorous analysis of whether the requirement that fiscal policy ensures debt stability conflicts with the use of fiscal policy for macroeconomic stabilization. A microfounded model can also allow us to derive a social welfare metric (see Woodford 2003), which can be used to rank policy outcomes.

A number of recent papers have examined joint stabilization by monetary and fiscal authorities acting optimally in the context of microfounded models with derived social welfare in a closed economy setting; see Benigno and Woodford (2004), Dixit and Lambertini (2003), Schmitt-Grohe and Uribe (2004), among many others. This approach can be extended to analyze a monetary union, with a union-wide monetary authority and individual national fiscal authorities. A natural setup to adopt here is a two-country framework, where the union as a whole is a closed economy, and we follow this approach. (In contrast, Gali and Monacelli 2005b assume the union is made up of a number of economies that are "small" in relation to the union, which reduces the extent of interaction between economies.)

Our analytical framework is perhaps closest to that of a recent paper by Beetsma and Jensen (2005), whose model is in turn based on a model developed in Benigno and Benigno (2000). However our analysis is more general than theirs in three important respects. (1) First, while their representative consumers are identical across countries (and therefore consume an identical basket), we allow for some home bias in consumption, along lines that are familiar from Gali and Monacelli (2005a), for example. …

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