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Compatibility between monetary and fiscal policy under EMU

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  • Leith, Campbell
  • Wren-Lewis, Simon

Abstract

The potential importance of fiscal policy in influencing inflation has recently been highlighted, following Woodford (1998), under the heading of the ‘Fiscal Theory of the Price Level’ (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 Info

Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 50 (2006)
Issue (Month): 6 (August)
Pages: 1529-1556

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Handle: RePEc:eee:eecrev:v:50:y:2006:i:6:p:1529-1556

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References

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  1. Steven A. Symansky & Douglas Laxton & Hamid Faruqee, 1996. "Government Debt, Life-Cycle Income and Liquidity Constrains: Beyond Approximate Ricardian Equivalence," IMF Working Papers 96/140, International Monetary Fund.
  2. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," CEPR Discussion Papers 1131, C.E.P.R. Discussion Papers.
  3. Gali, Jordi, 1994. "Government size and macroeconomic stability," European Economic Review, Elsevier, vol. 38(1), pages 117-132, January.
  4. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers 640, Board of Governors of the Federal Reserve System (U.S.).
  5. John H. Cochrane, 1998. "A Frictionless View of U.S. Inflation," NBER Working Papers 6646, National Bureau of Economic Research, Inc.
  6. Galí, Jordi & Gertler, Mark & López-Salido, J David, 2001. "European Inflation Dynamics," CEPR Discussion Papers 2684, C.E.P.R. Discussion Papers.
  7. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  8. Anil K. Kashyap, 1991. "Sticky prices: new evidence from retail catalogs," Working Paper Series, Macroeconomic Issues 91-26, Federal Reserve Bank of Chicago.
  9. Marvin Goodfriend & Robert King, 1997. "The New Neoclassical Synthesis and the Role of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 231-296 National Bureau of Economic Research, Inc.
  10. C.A. Sims, 1999. "The Precarious Fiscal Foundations of EMU," DNB Staff Reports (discontinued) 34, Netherlands Central Bank.
  11. Bergin, Paul R., 2000. "Fiscal solvency and price level determination in a monetary union," Journal of Monetary Economics, Elsevier, vol. 45(1), pages 37-53, February.
  12. Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
  13. Matthew B. Canzoneri & Robert E. Cumby & Behzad T. Diba, 1998. "Is the Price Level Determined by the Needs of Fiscal Solvency?," NBER Working Papers 6471, National Bureau of Economic Research, Inc.
  14. Dupor, Bill, 2000. "Exchange rates and the fiscal theory of the price level," Journal of Monetary Economics, Elsevier, vol. 45(3), pages 613-630, June.
  15. Canzoneri, Matthew B & Cumby, Robert E & Diba, Behzad T, 2001. "Fiscal Discipline and Exchange Rate Systems," Economic Journal, Royal Economic Society, vol. 111(474), pages 667-90, October.
  16. Leith, Campbell & Wren-Lewis, Simon, 2000. "Interactions between Monetary and Fiscal Policy Rules," Economic Journal, Royal Economic Society, vol. 110(462), pages C93-108, March.
  17. Woodford, Michael, 1995. "Price-level determinacy without control of a monetary aggregate," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 43(1), pages 1-46, December.
  18. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-71, October.
  19. Daniel, Betty C., 2001. "The fiscal theory of the price level in an open economy," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 293-308, October.
  20. Campbell leith & Jim Malley, 2002. "Estimated General Equilibrium Models for the Evaluation of Monetary Policy in the US and Europe," Working Papers 2001_16, Business School - Economics, University of Glasgow.
  21. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
  22. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  23. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Active and Passive at the ECB
    by Mainly Macro in Mainly Macro on 2012-09-30 14:31:00
  2. The ECB as a Lender of Last Resort to Governments
    by Mainly Macro in Mainly Macro on 2013-04-12 15:46:00
  3. How a Greek drama became a global tragedy
    by Mainly Macro in Mainly Macro on 2013-06-13 12:55:00
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