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On Prosperity and Posterity: The Need for Fiscal Discipline in a Monetary Union

  • Carsten Detken

    (European Central Bank)

  • Vítor Gaspar

    (European Central Bank)

  • Bernhard Winkler

    (European Central Bank)

We show how in a Blanchard-Yaari, overlapping generations framework, perfect substitutability of government bonds in Monetary Union tempts governments to exploit the enlarged common pool of savings. In Nash equilibrium all governments increase their bond financed transfers to current generations (prosperity effect) at the expense of future generations (posterity effect). The resulting deficit bias occurs even if one assumes that before Monetary Union countries had eliminated their deficit bias by designing appropriate domestic institutions. The paper provides a rationale for an increased focus on fiscal discipline in Monetary Union, without the need to assume imperfect credibility of existing Treaty provisions or to refer to extreme situations involving sovereign default. We draw on existing empirical evidence to argue that the degree of government bond substitutability within the European Monetary Union is an order of magnitude larger than in the global economy.

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Paper provided by Departamento de Economia, Gestão e Engenharia Industrial, Universidade de Aveiro in its series Working Papers de Economia (Economics Working Papers) with number 30.

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Length: 36 pages
Date of creation: Dec 2005
Date of revision:
Handle: RePEc:ave:wpaper:302005
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  19. Bernoth, Kerstin & von Hagen, Jürgen & Schuknecht, Ludger, 2003. "Sovereign risk premia in the European government bond market," ZEI Working Papers B 26-2003, ZEI - Center for European Integration Studies, University of Bonn.
  20. Buiter, Willem H, 1988. "Death, Birth, Productivity Growth and Debt Neutrality," Economic Journal, Royal Economic Society, vol. 98(391), pages 279-93, June.
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