The interaction between a common monetary policy targeting inflation and decentralized fiscal policies aiming at output stability is considered in a setting taking into account interdependencies between countries running via trade links and the common monetary policy. The setting is sufficiently general to capture various effects of fiscal policy, and to allow for both demand and supply shocks, which can be either aggregate or idiosyncratic. It is shown that a policy mix problem arises between the common monetary policy and the decentralized fiscal policy, which results in an inappropriate stabilization of shocks. In the case of aggregate shocks the inefficiency in responding to shocks is increasing in the number of member countries, while it is decreasing in the case of idiosyncratic shocks. Numerical illustrations show that the cost of non-cooperative fiscal policies can be large in the case of aggregate shocks, while they are small in the case of idiosyncratic shocks, provided that fiscal policy can be flexibly adjusted to cope with idiosyncratic shocks.
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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
3232.
Find related papers by JEL classification: E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy 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
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