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Monetary and Fiscal Policy Interactions in a Micro-Funded Model of a Monetary Union

So far, the 'New Open Economy Macroeconomics' literature has primarily focused on monetary policy and monetary policy rules, rather than paying attention also to fiscal policy. This is an omission because, especially with the advent of EMU, the burden on fiscal policy as an instrument for macroeconomic stabilization has potentially increased. In this Paper, we focus on the interactions between monetary and fiscal policy in a micro-founded model of monetary union. By extending a two-country, New-Keynesian model with public spending, we find that the forward-looking Phillips curves depend on consumption, terms of trade and public spending deviations from their respective stochastic natural rates. We study the optimal coordinated monetary and fiscal policies for various settings. Generally, we find that the gains from policy commitment and from the use of fiscal policy as an instrument for stabilization are economically non-trivial. We also consider simple monetary and fiscal policy rules and investigate to what extent these rules can approximate the optimal solution under commitment.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3591.

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Date of creation: Oct 2002
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Handle: RePEc:cpr:ceprdp:3591
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