Adhere to the rules or be discretionary? Empirical evidence from the euro area

This paper constructs a framework for modelling the interaction between monetary and fiscal policies before and after the formation of the euro area with a view to determining how and why member states’ fiscal policies become more discretionary after the adoption of the euro. Two hypotheses are theoretically derived and empirically tested, developing results with predictions in a robust manner based on various checks. The paper concludes that prior to joining the euro area, the fiscal policies of the member states only respond to demand shocks. However, after joining the euro area, states follow a more discretionary approach that suits both demand and supply shocks, whether domestically or abroad and regardless of the strict rules of the Stability and Growth Pact and other treaties, particularly in response to adverse shocks. This change in fiscal policies in response to economic shocks originates from the asymmetric policy structure: a common monetary policy outlined by the European Central Bank in the euro area, which contrasts with the fiscal policies determined individually by national governments. Although the European Union has been consolidating its governance structure since the recent global financial crisis and the ensuing European sovereign-debt crisis, substantial efforts continue to be required to transform the euro area into a thorough and genuine economic and monetary union.