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Regional inflation in a currency union: fiscal policy vs. fundamentals

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  • Duarte, Margarida
  • Wolman, Alexander L.

Abstract

We develop a general equilibrium model of a two-region currency union. There are two types of goods: non-traded goods, and traded goods for which markets are segmented. Monetary policy is set by a central monetary authority and is non-neutral due to nominal price rigidities. Fiscal policy is determined at the regional level by each region's government. We find that productivity shock alone generate significant variation in inflation across the two countries. Government spending shocks, in contrast, do not account for a significant portion of inflation variation. Varying relative country sie, we find that smaller countries experience higher variability of their inflation differential in response to shocks to productivity growth. Moreover, we show that regional governments can suppress incipient inflation differential associated with shock to productivityt growth by letting the income tax rate respond negatively to inflation differentials. JEL Classification: E31, E32, F41, H63

Suggested Citation

  • Duarte, Margarida & Wolman, Alexander L., 2002. "Regional inflation in a currency union: fiscal policy vs. fundamentals," Working Paper Series 180, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:2002180
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    More about this item

    Keywords

    currency union; fiscal policy; inflation differentials; nominal rigidities; productivity differentials;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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