Compatibility between monetary and fiscal policy under EMU
AbstractThe potential importance of fiscal policy in influencing inflation has recently been highlighted, following Woodford (1998), under the heading of the âFiscal Theory of the Price Levelâ (FTPL). Some authors have suggested that this theory provides a rationale for the Pact for Stability and Growth as a necessary condition for the ECB pursuing a policy of price stability. In this paper, we relax the assumptions underpinning the FTPL by developing a two country open economy model, where each country has overlapping generations of non-Ricardian consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have formed a monetary union, but where the fiscal authorities remain independent. We show that the fiscal response required to ensure solvency is greater when consumers are not infinitely lived, and that although this allows for some compensating behaviour between governments, in general, both fiscal policies must remain solvent if the ECB is to aggressively target inflation. We also show that the monetary authority can abandon its active targeting of inflation to ensure the solvency of at most one fiscal authority. Any other combination of policies will either result in price level indeterminacy and/or indefinite transfers of wealth between the two economies. Finally, in a series of simulations we show that fiscal shocks have limited impact on output and inflation provided the fiscal authorities meet the (weak) requirements of fiscal solvency. However, when monetary policy is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.
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Bibliographic InfoArticle provided by Elsevier in its journal European Economic Review.
Volume (Year): 50 (2006)
Issue (Month): 6 (August)
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Web page: http://www.elsevier.com/locate/eer
Other versions of this item:
- Campbell leith & Simon Wren-Lewis, . "Compatibility Between Monetary and Fiscal Policy Under EMU," Working Papers 2001_15, Business School - Economics, University of Glasgow.
- Leith, Campbell & Simon Wren-Lewis, 2002. "Compatibility Between Monetary and Fiscal Policy Under EMU," Royal Economic Society Annual Conference 2002 124, Royal Economic Society.
- E10 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - General
- E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
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