The paper emphasizes the distinction between the purely fiscal reasons for fiscal policy coordination under EMU (given a credible low-inflation policy by the ECB), and the spillover effects of an uncoordinated fiscal policy on monetary policy. The worst scenario is where an independent ECB sets the common interest rate and responds to a rising government debt/GDP ratio in either of the two `countries' with a looser monetary stance. The result is high inflation, high debt/GDP ratios and a large public sector. In our intermediate scenario the ECB sets the nominal interest rate and the fiscal authorities bear sole responsibility for their own solvency. The result again, is an excessively large public sector, but government debt is contained and inflation is kept low. In these first two scenarios fiscal policy coordination (with an independent ECB) is counterproductive. The best scenario occurs with credible inflation targeting by the ECB. This removes the incentive for the fiscal authorities to cause surprise inflation. Welfare gains from fiscal coordination now exist but are only substantial in a two-good EMU.
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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
701.
Find related papers by JEL classification: E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy F15 - International Economics - - Trade - - - Economic Integration F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
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