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Macroeconomic Tradeoffs in the United States and Europe: Fiscal Distortions and the International Monetary Regime

Listed author(s):
  • Barry Eichengreen

    (University of California, Berkeley)

  • Fabio Ghironi


    (Boston College)

This paper studies the impact of changes in the extent to which fiscal policy is distortionary on the short-run macroeconomic tradeoffs facing fiscal policymakers in an era of budget equilibrium. It does so in an open economy framework, that we use to interpret U.S.-European policy interactions. Our analysis features both fiscal and monetary policy to study how changes in the extent to which fiscal policy is distortionary affect the interaction between central banks and fiscal authorities, both intra- and internationally. In addition, strategic interactions among policymakers≥and the tradeoffs they face≥are affected by the exchange-rate regime. When government spending is funded through distortionary taxes alone≥a scenario that we call anti-Keynesian, changing spending moves both inflation and employment in the desired direction following a worldwide supply shock. Smaller and more open economies face a more favorable tradeoff than large relatively closed ones. Under a managed exchange rate regime, European governments face a better tradeoff than under flexible rates, but the improvement is more significant for the country that controls the exchange rate. When both European countries in our model join in a monetary union, the country that had control of the exchange rate under the managed exchange rate regime faces a worse tradeoff, while the tradeoff improves for the country that controlled money supply. In the fully Keynesian case, in which taxes are non-distortionary, all countries face the same positively sloped tradeoff regardless of the exchange-rate regime. Increases in spending cause both output and inflation to rise. When fiscal policy is neither fully anti-Keynesian nor fully Keynesian, the governments' tradeoffs lie in between the extreme cases, and the exact position depends on the extent to which fiscal policy is Keynesian. Under all European exchange-rate regimes, small increases in the fraction of firms that are subject to distortionary taxation at home are beneficial when the equilibrium is characterized by unemployment, while a less Keynesian fiscal policy abroad is harmful. Governments in the U.S. and Europe will want the ECB and the Fed to coordinate their reactions to an unfavorable supply shock, while monetary policymakers will have little incentive to do so. Intra-European fiscal cooperation can be counterproductive, whereas cooperation between governments and central banks inside each continent can be beneficial. Our study suggests that, if governments are concerned mainly about the relation between fiscal policy and the business cycle, maintaining some fiscal distortions may be optimal.

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Paper provided by Boston College Department of Economics in its series Boston College Working Papers in Economics with number 467.

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Length: 54 pages
Date of creation: 22 Nov 1999
Handle: RePEc:boc:bocoec:467
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  1. Fabio Ghironi, 2000. "U.S.-Europe Economic Interdependence and Policy Transmission," Boston College Working Papers in Economics 470, Boston College Department of Economics.
  2. Ardagna, Silvia & Alesina, Alberto, 1998. "Tales of Fiscal Adjustment," Scholarly Articles 2579822, Harvard University Department of Economics.
  3. Alberto Alesina & Silvia Ardagna & Roberto Perotti & Fabio Schiantarelli, 2002. "Fiscal Policy, Profits, and Investment," American Economic Review, American Economic Association, vol. 92(3), pages 571-589, June.
  4. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
  5. Beetsma, Roel M. W. J. & Lans Bovenberg, A., 1998. "Monetary union without fiscal coordination may discipline policymakers," Journal of International Economics, Elsevier, vol. 45(2), pages 239-258, August.
  6. Francesco Giavazzi & Marco Pagano, 1990. "Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries," NBER Chapters,in: NBER Macroeconomics Annual 1990, Volume 5, pages 75-122 National Bureau of Economic Research, Inc.
  7. Alberto Alesina & Silvia Ardagna, 1998. "Tales of fiscal adjustment," Economic Policy, CEPR;CES;MSH, vol. 13(27), pages 487-545, October.
  8. Gilles Saint Paul, 1998. "The political consequences of unemployment," Economics Working Papers 343, Department of Economics and Business, Universitat Pompeu Fabra.
  9. Francesco Giavazzi & Marco Pagano, 1995. "Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience," NBER Working Papers 5332, National Bureau of Economic Research, Inc.
  10. Matthew B. Canzoneri & Dale W. Henderson, 1991. "Monetary Policy in Interdependent Economies: A Game-Theoretic Approach," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262031787, January.
  11. Artis, Michael J & Gazioglu, Saziye, 1987. "A Two-Country Model with Asymmetric Phillips Curves and Intervention in the Foreign Exchange Market," CEPR Discussion Papers 172, C.E.P.R. Discussion Papers.
  12. Chari, V.V. & Kehoe, Patrick J., 2007. "On the need for fiscal constraints in a monetary union," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2399-2408, November.
  13. D. Begg & F. Giavazzi & Ch. Wyplosz, 1999. "Options for the Future Exchange RatePolicy of the EMU," VOPROSY ECONOMIKI, N.P. Redaktsiya zhurnala "Voprosy Economiki", vol. 1.
  14. Ghironi, Fabio & Giavazzi, Francesco, 1998. "Currency areas, international monetary regimes, and the employment-inflation tradeoff," Journal of International Economics, Elsevier, vol. 45(2), pages 259-296, August.
  15. Eichengreen, Barry & Ghironi, Fabio, 1997. "How Will Transatlantic Policy Interactions Change with the Advent of EMU?," CEPR Discussion Papers 1643, C.E.P.R. Discussion Papers.
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