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

Author

Listed:
  • Barry Eichengreen

    (University of California, Berkeley)

  • Fabio Ghironi

    () (Boston College)

Abstract

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.

Suggested Citation

  • Barry Eichengreen & Fabio Ghironi, 1999. "Macroeconomic Tradeoffs in the United States and Europe: Fiscal Distortions and the International Monetary Regime," Boston College Working Papers in Economics 467, Boston College Department of Economics.
  • Handle: RePEc:boc:bocoec:467
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    References listed on IDEAS

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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.
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    Cited by:

    1. Paul Cavelaars, 2000. "Double Discretion, International Spillovers and the Welfare Implications of Monetary Unification," MEB Series (discontinued) 2000-12, Netherlands Central Bank, Monetary and Economic Policy Department.
    2. Laurence H. Meyer & Brian M. Doyle & Joseph E. Gagnon & Dale W. Henderson, 2002. "International coordination of macroeconomic policies: still alive in the new millennium?," International Finance Discussion Papers 723, Board of Governors of the Federal Reserve System (U.S.).
    3. Fabio Ghironi, 2000. "U.S.-Europe Economic Interdependence and Policy Transmission," Boston College Working Papers in Economics 470, Boston College Department of Economics.

    More about this item

    Keywords

    Employment-inflation tradeoff; Exchange-rate regimes; Fiscal distortions; Fiscal policy; International cooperation; Monetary policy;

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal 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; Treasury Policy
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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