A Simple Model of a Monetary Union

This paper explicitly models strategic interaction between two independent national fiscal authorities and a single central bank in a simple New Keynesian model of a monetary union. Closed analytical solutions for the policy instruments are computed for several strategic games. The analytical results depend nonlinearly on parameters of the model. Thus, impulse response graphs to various shocks are discussed. Depending on the kind of disturbance, various results can be drawn: First, intraunion spillover effects dampen or amplify the shock. Second, policy instruments do not only serve as complements, but severe conflicts on the direction of monetary and fiscal policy might arise. Third, coordinated policy does not lead to the best outcome in terms of welfare. Fourth, central banks have an incentive to be leader when setting instruments if the economies are hit by cost-push shocks, because this policy regime reduces their welfare losses, whereas governments wish either to coordinate all policies or set all instruments simultaneously.