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Discretionary Fiscal Policy and Optimal Monetary Policy in a Currency Area

  • S. Gnocchi

The paper evaluates the effects of fiscal discretion in a currency area, where a common and independent monetary authority commits to optimally set the union-wide nominal interest rate. National governments implement fiscal policy by choosing government expenditure. The assumption of fiscal policy coordination across countries is retained in order to evaluate the costs exclusively due to discretion, leaving aside the free-riding problems stemming from noncooperation. In such a context, nominal rigidities potentially generate a stabilization role for fiscal policy, in addition to the one of ensuring efficient provision of public goods. However, it is showed that, under discretion, aggregate fiscal policy stance is inefficiently loose and the volatility of government expenditure is higher than optimal. As an implication, the optimal monetary policy rule involves the targeting of union-wide fiscal stance, on top of inflation and output gap. The result questions the welfare enhancing role of government expenditure, as the proper instrument for stabilizing asymmetric shocks. In fact, discretion entails significant welfare costs, the magnitude depending on the stochastic properties of the shocks and, for plausible parameter values, it is not optimal to use fiscal policy as a stabilization tool.

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Paper provided by Dipartimento Scienze Economiche, Universita' di Bologna in its series Working Papers with number 602.

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Date of creation: Sep 2007
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Handle: RePEc:bol:bodewp:602
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  1. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," CEPR Discussion Papers 2942, C.E.P.R. Discussion Papers.
  2. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
  3. Simon Wren-Lewis & Campbell Leith, 2007. "Fiscal Sustainability in a New Keynesian Model," Economics Series Working Papers 310, University of Oxford, Department of Economics.
  4. Luisa Lambertini, 2004. "Monetary-Fiscal Interactions with a Conservative Central Bank," 2004 Meeting Papers 627, Society for Economic Dynamics.
  5. Schmitt-Grohe, Stephanie & Uribe, Martin, 2007. "Optimal simple and implementable monetary and fiscal rules," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1702-1725, September.
  6. Galí, Jordi & Monacelli, Tommaso, 2005. "Optimal Monetary and Fiscal Policy in a Currency Union," CEPR Discussion Papers 5374, C.E.P.R. Discussion Papers.
  7. Kenneth Rogoff, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, Oxford University Press, vol. 100(4), pages 1169-1189.
  8. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  9. Klaus Adam & Roberto M. Billi, 2007. "Monetary conservatism and fiscal policy," Research Working Paper RWP 07-01, Federal Reserve Bank of Kansas City.
  10. Beetsma, Roel M. W. J. & Jensen, Henrik, 2004. "Mark-up fluctuations and fiscal policy stabilization in a monetary union," Journal of Macroeconomics, Elsevier, vol. 26(2), pages 357-376, June.
  11. Ferrero, Andrea, 2005. "Fiscal and monetary rules for a currency union," Working Paper Series 0502, European Central Bank.
  12. Dixit, Avinash & Lambertini, Luisa, 2001. "Monetary-fiscal policy interactions and commitment versus discretion in a monetary union," European Economic Review, Elsevier, vol. 45(4-6), pages 977-987, May.
  13. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
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