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Optimal Monetary and Fiscal Policy in a Currency Union

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  • Jordi Galí
  • Tommaso Monacelli
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    Abstract

    We lay out a tractable model for fiscal and monetary policy analysis in a currency union, and analyze its implications for the optimal design of such policies. Monetary policy is conducted by a common central bank, which sets the interest rate for the union as a whole. Fiscal policy is implemented at the country level, through the choice of government spending level. The model incorporates country-specific shocks and nominal rigidities. Under our assumptions, the optimal monetary policy requires that inflation be stabilized at the union level. On the other hand, the relinquishment of an independent monetary policy, coupled with nominal price rigidities, generates a stabilization role for fiscal policy, one beyond the efficient provision of public goods. Interestingly, the stabilizing role for fiscal policy is shown to be desirable not only from the viewpoint of each individual country, but also from that of the union as a whole. In addition, our paper oers some insights on two aspects of policy design in currency unions: (i) the conditions for equilibrium determinacy and (ii) the effects of exogenous government spending variations.

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    Bibliographic Info

    Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 240.

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    Date of creation: Oct 2005
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    Handle: RePEc:bge:wpaper:240

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    Related research

    Keywords: Monetary Union; sticky prices; countercyclical policy; inflation differentials;

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    References

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    1. Maurice Obstfeld & Kenneth Rogoff, 2000. "New Directions for Stochastic Open Economy Models," International Finance 0004002, EconWPA.
    2. Ferrero, Andrea, 2005. "Fiscal and monetary rules for a currency union," Working Paper Series 0502, European Central Bank.
    3. Bullard, James & Mitra, Kaushik, 2002. "Learning about monetary policy rules," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1105-1129, September.
    4. Benigno, Pierpaolo, 2001. "Optimal Monetary Policy in a Currency Area," CEPR Discussion Papers 2755, C.E.P.R. Discussion Papers.
    5. Robert Kollmann, 2001. "The exchange rate in a dynamic-optimizing business cycle model with nominal rigidities: a quantitative investigation," ULB Institutional Repository 2013/7630, ULB -- Universite Libre de Bruxelles.
    6. Federico Trionfetti, 2000. "Discriminatory Public Procurement and International Trade," The World Economy, Wiley Blackwell, vol. 23(1), pages 57-76, 01.
    7. Linnemann, Ludger & Schabert, Andreas, 2003. " Fiscal Policy in the New Neoclassical Synthesis," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(6), pages 911-29, December.
    8. Gianluca Benigno & Pierpaolo Benigno, 2003. "Price Stability in Open Economies," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 743-764, October.
    9. Brulhart, Marius & Trionfetti, Federico, 2004. "Public expenditure, international specialisation and agglomeration," European Economic Review, Elsevier, vol. 48(4), pages 851-881, August.
    10. Lombardo, Giovanni & Sutherland, Alan, 2003. "Monetary and fiscal interactions in open economies," Working Paper Series 0289, European Central Bank.
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    Cited by:
    1. Oliver Grimm & Stefan Ried, 2007. "Macroeconomic Policy in a Heterogeneous Monetary Union," CER-ETH Economics working paper series 07/67, CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich.
    2. Klaus Adam & Roberto M. Billi, 2007. "Monetary conservatism and fiscal policy," Research Working Paper RWP 07-01, Federal Reserve Bank of Kansas City.
    3. S. Gnocchi, 2007. "Discretionary Fiscal Policy and Optimal Monetary Policy in a Currency Area," Working Papers 602, Dipartimento Scienze Economiche, Universita' di Bologna.
    4. Chiara Forlati, 2004. "On optimal monetary and fiscal policy interactions in open economies," Economics Working Papers 949, Department of Economics and Business, Universitat Pompeu Fabra, revised Mar 2006.

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