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Overturning Mundell: fiscal policy in a monetary union

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Russell Cooper
Hubert Kempf

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Abstract

Central to ongoing debates over the desirability of monetary unions is a supposed trade-off, outlined by Mundell [1961]: a monetary union reduces transactions costs but renders stabilization policy less effective. If shocks across countries are sufficiently correlated, then, according to this argument, delegating monetary policy to a single central bank is not very costly and a monetary union is desirable.> This paper explores this argument in a setting with both monetary and fiscal policies. In an economy with monetary policy alone, we confirm the presence of the trade-off and find that indeed a monetary union will not be welfare improving if the correlation of national shocks is too low. However, fiscal interventions by national governments, combined with a central bank that has the ability to commit to monetary policy, overturn these results. In equilibrium, such a monetary union will be welfare improving for any correlation of shocks.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Staff Report with number 311.

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Date of creation: 2002
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Handle: RePEc:fip:fedmsr:311

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Keywords: Monetary unions ; Econometric models;

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  1. Hubert Kempf & Leopold von Thadden, 2008. "On policy interactions among nations. When do cooperation and commitment matter?," Working Paper Series 880, European Central Bank. [Downloadable!]
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  2. Cristina Arellano & Jonathan Heathcote, 2007. "Dollarization and financial integration," Staff Report 385, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  3. Arthur Grimes, 2005. "Regional and Industry Cycles in Australasia: Implications for a Common Currency," Working Papers 05_04, Motu Economic and Public Policy Research. [Downloadable!]
    Other versions:
  4. Hubert KEMPF, 2006. "The Constitutional Treaty of the EU and the institutional framework," Departemental Working Papers 2006-05, Department of Economics University of Milan Italy. [Downloadable!]
  5. Aurélien Eyquem (CREM - CNRS), 2007. "Fiscal Policy in an Estimated Model of the European Monetary Union," Economics Working Paper Archive (University of Rennes 1 & University of Caen) 200705, Center for Research in Economics and Management (CREM), University of Rennes 1, University of Caen and CNRS. [Downloadable!]
  6. René Cabral-Torres, . "Monetary and Fiscal Policy Coordination," Discussion Papers 05/28, Department of Economics, University of York. [Downloadable!]
  7. Marcelo Sánchez, 2008. "Monetary stabilisation in a currency union of small open economies," Working Paper Series 927, European Central Bank. [Downloadable!]
  8. B. Gabriela Mundaca & Jon Strand, 2004. "A Risk Allocation Approach to Optimal Exchange Rate Policy," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  9. Arthur Grimes, 2005. "New Zealand: A Typical Australasian Economy?," Economic History 0509004, EconWPA. [Downloadable!]
    Other versions:
  10. Adao, Bernardino & Correia, Maria Isabel Horta & Teles, Pedro, 2006. "On the Relevance of Exchange Rate Regimes for Stabilization Policy," CEPR Discussion Papers 5797, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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