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Central bank reaction to public deficit and sound public finance: the case of the European Monetary Union

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Canale, R.R.

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Abstract

The paper aims to shed light on the relation between monetary and fiscal policy in EMU, focusing on the interest rates and deficit dynamics. We present a theoretical model in which monetary and fiscal policy independently interact in a closed economic system through their own instrument, namely, the rate of interest for the central bank and deficit spending for governments. We demonstrate that the possibility of the two policy authorities producing not conflicting results depends on the idea each has of the workings of the economic system and on the influence each variable has on inflation and equilibrium income. Furthermore the inflationary opinion of the ECB about deficit spending leads to the result that public finance becomes surely unsound, unless governments stop using expansionary instruments. We provocatively conclude that the limits set by the Maastricht Treaty are a necessary solution to avoid unsound public finance.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 8789.

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Date of creation: 10 May 2008
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Handle: RePEc:pra:mprapa:8789

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Related research
Keywords: Monetary policy Fiscal Policy Policy coordination EMU

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Find related papers by JEL classification:
E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization
E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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  3. Blanchard, Olivier J, 1985. "Debt, Deficits, and Finite Horizons," Journal of Political Economy, University of Chicago Press, vol. 93(2), pages 223-47, April. [Downloadable!] (restricted)
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  5. Galí, Jordi & Monacelli, Tommaso, 2005. "Optimal Monetary and Fiscal Policy in a Currency Union," CEPR Discussion Papers 5374, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  6. James Tobin, 2001. "Fiscal Policy: Its Macroeconomics in Perspective," Cowles Foundation Discussion Papers 1301, Cowles Foundation, Yale University. [Downloadable!]
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  19. Eichengreen, Barry & Bayoumi, Tamim, 1994. "The political economy of fiscal restrictions: Implications for Europe from the United States," European Economic Review, Elsevier, vol. 38(3-4), pages 783-791, April. [Downloadable!] (restricted)
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  20. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June. [Downloadable!] (restricted)
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