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How Do Monetary and Fiscal Policy Interact in the European Monetary Union?

In: NBER International Seminar on Macroeconomics 2004

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  • Matthew B. Canzoneri
  • Robert E. Cumby
  • Behzad T. Diba

Abstract

Formation of the Euro area raises new questions about the coordination of monetary and fiscal policy. Using a New Neoclassical Synthesis (NNS) model, we show that a common monetary policy, responding to area-wide aggregates, has asymmetric effects on countries within the union, depending on whether they are large or small, or whether they have high or low debts. We analyze the implications of these asymmetries for the various countries welfare and for their fiscal policies. We also study rules for setting national tax and spending rates, rules that constrain movements in the deficit to GDP ratio. We ask whether these rules are necessary for the common monetary policy to be able to harmonize national inflation rates, and we analyze their effects on national welfare. We also discuss some potential failings of our model (and perhaps NNS models generally); in particular, our model's variance decompositions suggest that productivity shocks may play an inordinately large role, while fiscal shocks (or demand shocks generally) may play too small a role (even when 'rule of thumb' spenders are added).

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This chapter was published in:

  • Richard H. Clarida & Jeffrey Frankel & Francesco Giavazzi & Kenneth D. West, 2006. "NBER International Seminar on Macroeconomics 2004," NBER Books, National Bureau of Economic Research, Inc, number clar06-1, January.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 0078.

    Handle: RePEc:nbr:nberch:0078

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    References

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    1. Andrew Levin & Christopher J. Erceg & Dale W. Henderson, 1999. "Optimal Monetary Policy with Staggered Wage and Price Contracts," Computing in Economics and Finance 1999 1151, Society for Computational Economics.
    2. Olivier Blanchard & Roberto Perotti, 2002. "An Empirical Characterization Of The Dynamic Effects Of Changes In Government Spending And Taxes On Output," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 117(4), pages 1329-1368, November.
    3. Jordi Galí & J. David López-Salido & Javier Vallés, 2002. "Understanding the effects of government spending on consumption," Economics Working Papers 911, Department of Economics and Business, Universitat Pompeu Fabra, revised Aug 2005.
    4. Duarte, Margarida & Wolman, Alexander L., 2002. "Regional inflation in a currency union: fiscal policy vs. fundamentals," Working Paper Series, European Central Bank 0180, European Central Bank.
    5. Harris Dellas & Fabrice Collard, 2004. "Inflation targeting," Computing in Economics and Finance 2004, Society for Computational Economics 97, Society for Computational Economics.
    6. Surico, Paolo, 2003. "How does the ECB target inflation?," Working Paper Series, European Central Bank 0229, European Central Bank.
    7. Robert Kollmann, 2004. "Welfare Maximizing Monetary and Fiscal Policy Rules," Computing in Economics and Finance 2004, Society for Computational Economics 102, Society for Computational Economics.
    8. Smets, Frank & Wouters, Raf, 2002. "An estimated stochastic dynamic general equilibrium model of the euro area," Working Paper Series, European Central Bank 0171, European Central Bank.
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    Cited by:
    1. Duarte, Margarida & Wolman, Alexander L., 2008. "Fiscal policy and regional inflation in a currency union," Journal of International Economics, Elsevier, vol. 74(2), pages 384-401, March.
    2. PLASMANS, Joseph & FORNERO, Jorge & MICHALAK, Tomasz, 2006. "A microfounded sectoral model for open economies," Working Papers 2007013, University of Antwerp, Faculty of Applied Economics.
    3. Margarida Duarte & Alexander L. Wolman, 2002. "Regional inflation in a currency union: fiscal policy vs. fundamentals," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 746, Board of Governors of the Federal Reserve System (U.S.).
    4. Ludger Linnemann & Andreas Schabert, 2004. "Debt Non-Neutrality, Policy Interactions, and Macroeconomic Stability," Working Paper Series in Economics, University of Cologne, Department of Economics 12, University of Cologne, Department of Economics.
    5. repec:dgr:uvatin:2005077 is not listed on IDEAS
    6. Evi Pappa, 2005. "The Unbearable Tightness of Being in a Monetary Union: Fiscal Restrictions and Regional Stability"," Working Papers 294, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
    7. Lipińska, Anna & von Thadden, Leopold, 2009. "Monetary and fiscal policy aspects of indirect tax changes in a monetary union," Working Paper Series, European Central Bank 1097, European Central Bank.
    8. Ferrero, Andrea, 2009. "Fiscal and monetary rules for a currency union," Journal of International Economics, Elsevier, vol. 77(1), pages 1-10, February.
    9. Oliver Grimm & Stefan Ried, 2007. "Macroeconomic Policy in a Heterogeneous Monetary Union," SFB 649 Discussion Papers SFB649DP2007-028, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.

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