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How Do Monetary and Fiscal Policy Interact in the European Monetary Union?

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  • Matthew B. Canzoneri
  • Robert E. Cumby
  • Behzad T. Diba

Abstract

Formation of the Euro area raises new questions about the coordination of monetary and fiscal policy. Using a New Neoclassical Synthesis (NNS) model, we show that a common monetary policy, responding to area-wide aggregates, has asymmetric effects on countries within the union, depending on whether they are large or small, or whether they have high or low debts. We analyze the implications of these asymmetries for the various countries welfare and for their fiscal policies. We also study rules for setting national tax and spending rates, rules that constrain movements in the deficit to GDP ratio. We ask whether these rules are necessary for the common monetary policy to be able to harmonize national inflation rates, and we analyze their effects on national welfare. We also discuss some potential failings of our model (and perhaps NNS models generally); in particular, our model's variance decompositions suggest that productivity shocks may play an inordinately large role, while fiscal shocks (or demand shocks generally) may play too small a role (even when 'rule of thumb' spenders are added).

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11055.

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Date of creation: Jan 2005
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Publication status: published as How Do Monetary and Fiscal Policy Interact in the European Monetary Union? , Matthew B. Canzoneri, Robert E. Cumby, Behzad T. Diba. in NBER International Seminar on Macroeconomics 2004 , Clarida, Frankel, Giavazzi, and West. 2006
Handle: RePEc:nbr:nberwo:11055

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  1. Jordi Gali & David López-Salido & Javier Valles, 2004. "Understanding the effects of government spending on consumption," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 805, Board of Governors of the Federal Reserve System (U.S.).
  2. Olivier Blanchard & Roberto Perotti, 1999. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output," NBER Working Papers 7269, National Bureau of Economic Research, Inc.
  3. Harris Dellas & Fabrice Collard, 2004. "Inflation targeting," Computing in Economics and Finance 2004, Society for Computational Economics 97, Society for Computational Economics.
  4. Paolo Surico, 2003. "How does the ECB target inflation?," Macroeconomics, EconWPA 0305005, EconWPA.
  5. Duarte, Margarida & Wolman, Alexander L., 2002. "Regional inflation in a currency union: fiscal policy vs. fundamentals," Working Paper Series, European Central Bank 0180, European Central Bank.
  6. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 640, Board of Governors of the Federal Reserve System (U.S.).
  7. Smets, Frank & Wouters, Raf, 2002. "An estimated stochastic dynamic general equilibrium model of the euro area," Working Paper Series, European Central Bank 0171, European Central Bank.
  8. Robert Kollmann, 2004. "Welfare Maximizing Monetary and Fiscal Policy Rules," Computing in Economics and Finance 2004, Society for Computational Economics 102, Society for Computational Economics.
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Cited by:
  1. Plasmans, J.E.J. & Fornero, J. & Michalak, T., 2007. "A Microfounded Sectoral Model for Open Economies," Discussion Paper, Tilburg University, Center for Economic Research 2007-39, Tilburg University, Center for Economic Research.
  2. Pappa, Evi & Vassilatos, Vanghelis, 2007. "The unbearable tightness of being in a monetary union: Fiscal restrictions and regional stability," European Economic Review, Elsevier, Elsevier, vol. 51(6), pages 1492-1513, August.
  3. Ferrero, Andrea, 2005. "Fiscal and monetary rules for a currency union," Working Paper Series, European Central Bank 0502, European Central Bank.
  4. Ludger Linnemann & Andreas Schabert, 2010. "Debt Nonneutrality, Policy Interactions, And Macroeconomic Stability," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 51(2), pages 461-474, 05.
  5. Oliver Grimm & Stefan Ried, 2007. "Macroeconomic Policy in a Heterogeneous Monetary Union," CER-ETH Economics working paper series, CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich 07/67, CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich.
  6. Margarida Duarte & Alexander L. Wolman, 2002. "Regional inflation in a currency union: fiscal policy vs. fundamentals," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 746, Board of Governors of the Federal Reserve System (U.S.).
  7. Lipińska, Anna & von Thadden, Leopold, 2009. "Monetary and fiscal policy aspects of indirect tax changes in a monetary union," Working Paper Series, European Central Bank 1097, European Central Bank.
  8. Margarida Duarte & Alexander L. Wolman, 2003. "Fiscal policy and regional inflation in a currency union," Working Paper, Federal Reserve Bank of Richmond 03-11, Federal Reserve Bank of Richmond.
  9. Ludger Linnemann & Andreas Schabert, 2005. "Debt Non-Neutrality, Policy Interactions, and Macroeconomic Stability," Tinbergen Institute Discussion Papers 05-077/2, Tinbergen Institute.

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