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ECB vs Council vs Commission: Monetary and fiscal policy interactions in the EMU when cyclical conditions are uncertain

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  • Fabio Balboni
  • Marco Buti
  • Martin Larch

Abstract

This paper examines economic policy interactions in the Economic and Monetary Union when the assessment of cyclical conditions in real time is surrounded by uncertainty. On the basis of a simple stylised model it shows that different views about the output gap on the side of the policy players - the Council of the European Union, the European Commission and the European Central Bank - can affect the equilibrium outcome in terms of output, inflation, the budget deficit and the interest rate. More specifically, if fiscal and monetary policy decisions are taken simultaneously diverging views about the cycle can give rise to excessive activism as policy players try to push economic variables into opposite directions. The costs of such policy conflicts can be reduced by agreeing on a common assessment of the cycle, by constraining policy variables, by increasing the weight of fiscally conservative institutions. Another way to sidestep policy conflicts ensuing from diverging views of the cycle is to take policy decisions sequentially, as is the case in a Stackelberg-type of interaction. To the extent that misperceptions are random, the leader, who moves first, will assume that the follower's assessment will be in line with its own view of the cycle. This effectively precludes the kind of frictions arising in a simultaneous setup, because the leader cannot backtrack. For a given misperception of the cycle, the impact on the policy instruments and on output and inflation are generally smaller in the Stackelberg equilibrium as compared to a Nash outcome.

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Bibliographic Info

Paper provided by Directorate General Economic and Monetary Affairs (DG ECFIN), European Commission in its series European Economy - Economic Papers with number 277.

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Length: 34 pages
Date of creation: May 2007
Date of revision:
Handle: RePEc:euf:ecopap:0277

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Keywords: Monetary policy; Fiscal Policy; Economic and Monetary Union; real-time output gap estimates; Balboni; Buti; Larch;

References

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  1. Alan Ahearne & Jean Pisani-Ferry, 2006. "The Euro: only for the agile," Policy Briefs 42, Bruegel.
  2. Rolf Strauch & Mark Hallerberg & Jürgen von Hagen, 2004. "Budgetary Forecasts in Europe – The Track Record of Stability and Convergence Programmes," Economic Working Papers at Centro de Estudios Andaluces E2004/42, Centro de Estudios Andaluces.
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  12. Dixit, Avinash & Lambertini, Luisa, 2001. "Monetary-fiscal policy interactions and commitment versus discretion in a monetary union," European Economic Review, Elsevier, vol. 45(4-6), pages 977-987, May.
  13. Favero, Carlo A & Rovelli, Riccardo, 1999. "Modelling and Identifying Central Banks' Preferences," CEPR Discussion Papers 2178, C.E.P.R. Discussion Papers.
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  16. Lorenzo Forni & Sandro Momigliano, 2004. "Cyclical sensitivity of fiscal policies based on real-time data," Temi di discussione (Economic working papers) 540, Bank of Italy, Economic Research and International Relations Area.
  17. Marco Buti & Paul Noord, 2004. "Fiscal Discretion and Elections in the Early Years of EMU," Journal of Common Market Studies, Wiley Blackwell, vol. 42(4), pages 737-756, November.
  18. Ramon Gomez-Salvador & Alberto Musso & Marc Stocker & Jarkko Turunen, 2006. "Labour productivity developments in the euro area," Occasional Paper Series 53, European Central Bank.
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Cited by:
  1. Isabell Koske & Nigel Pain, 2008. "The Usefulness of Output Gaps for Policy Analysis," OECD Economics Department Working Papers 621, OECD Publishing.

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