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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 Matthew B. Canzoneri, Robert E. Cumby, Behzad T. Diba. "How Do Monetary and Fiscal Policy Interact in the European Monetary Union?," in Richard H. Clarida, Jeffrey Frankel, Francesco Giavazzi and Kenneth D. West, editors, "NBER International Seminar on Macroeconomics 2004" The MIT Press (2006)
Handle: RePEc:nbr:nberwo:11055

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References

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  1. Paolo Surico, 2003. "How does the ECB target inflation?," Working Paper Series 229, European Central Bank.
  2. Jordi Galí & J. David López-Salido & Javier Vallés, 2004. "Understanding the effects of government spending on consumption," Working Paper Series 339, European Central Bank.
  3. Robert Kollmann, 2004. "Welfare Maximizing Monetary and Fiscal Policy Rules," Computing in Economics and Finance 2004 102, Society for Computational Economics.
  4. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers 640, Board of Governors of the Federal Reserve System (U.S.).
  5. Frank Smets & Rafael Wouters, 2002. "An estimated stochastic dynamic general equilibrium model of the euro area," Working Paper Series 171, European Central Bank.
  6. Harris Dellas & Fabrice Collard, 2004. "Inflation targeting," Computing in Economics and Finance 2004 97, Society for Computational Economics.
  7. Olivier Blanchard & Roberto Perotti, 2002. "An Empirical Characterization Of The Dynamic Effects Of Changes In Government Spending And Taxes On Output," The Quarterly Journal of Economics, MIT Press, vol. 117(4), pages 1329-1368, November.
  8. Margarida Duarte & Alexander L. Wolman, 2002. "Regional inflation in a currency union: fiscal policy vs. fundamentals," International Finance Discussion Papers 746, Board of Governors of the Federal Reserve System (U.S.).
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Cited by:
  1. Pappa, Evi & Vassilatos, Vanghelis, 2007. "The unbearable tightness of being in a monetary union: Fiscal restrictions and regional stability," European Economic Review, Elsevier, vol. 51(6), pages 1492-1513, August.
  2. Ludger Linnemann & Andreas Schabert, 2005. "Debt Non-Neutrality, Policy Interactions, and Macroeconomic Stability," Tinbergen Institute Discussion Papers 05-077/2, Tinbergen Institute.
  3. Ferrero, Andrea, 2009. "Fiscal and monetary rules for a currency union," Journal of International Economics, Elsevier, vol. 77(1), pages 1-10, February.
  4. Margarida Duarte & Alexander L. Wolman, 2003. "Fiscal policy and regional inflation in a currency union," Working Paper 03-11, Federal Reserve Bank of Richmond.
  5. Jorge Fornero & Tomasz Michalak & Joseph Plasmans, 2007. "A Microfounded Sectoral Model for Open Economies," CESifo Working Paper Series 2052, CESifo Group Munich.
  6. Oliver Grimm & Stefan Ried, 2007. "Macroeconomic Policy in a Heterogeneous Monetary Union," SFB 649 Discussion Papers SFB649DP2007-028, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.

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