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How Do Monetary and Fiscal Policy Interact in the European Monetary Union?

  • Matthew B. Canzoneri
  • Robert E. Cumby
  • Behzad T. Diba

Formation of the Euro area raises new questions about the coordination of monetary and fiscal policy. Using a New Neoclassical Synthesis (NNS) model, we show that a common monetary policy, responding to area-wide aggregates, has asymmetric effects on countries within the union, depending on whether they are large or small, or whether they have high or low debts. We analyze the implications of these asymmetries for the various countries welfare and for their fiscal policies. We also study rules for setting national tax and spending rates, rules that constrain movements in the deficit to GDP ratio. We ask whether these rules are necessary for the common monetary policy to be able to harmonize national inflation rates, and we analyze their effects on national welfare. We also discuss some potential failings of our model (and perhaps NNS models generally); in particular, our model's variance decompositions suggest that productivity shocks may play an inordinately large role, while fiscal shocks (or demand shocks generally) may play too small a role (even when 'rule of thumb' spenders are added).

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File URL: http://www.nber.org/papers/w11055.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11055.

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Date of creation: Jan 2005
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Publication status: published as How Do Monetary and Fiscal Policy Interact in the European Monetary Union? , Matthew B. Canzoneri, Robert E. Cumby, Behzad T. Diba. in NBER International Seminar on Macroeconomics 2004 , Clarida, Frankel, Giavazzi, and West. 2006
Handle: RePEc:nbr:nberwo:11055
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  1. Andrew Levin & Christopher J. Erceg & Dale W. Henderson, 1999. "Optimal Monetary Policy with Staggered Wage and Price Contracts," Computing in Economics and Finance 1999 1151, Society for Computational Economics.
  2. Duarte, Margarida & Wolman, Alexander L., 2002. "Regional inflation in a currency union: fiscal policy vs. fundamentals," Working Paper Series 0180, European Central Bank.
  3. Galí, Jordi & López-Salido, J David & Vallés Liberal, Javier, 2005. "Understanding the Effects of Government Spending on Consumption," CEPR Discussion Papers 5212, C.E.P.R. Discussion Papers.
  4. Harris Dellas & Fabrice Collard, 2004. "Inflation targeting," Computing in Economics and Finance 2004 97, Society for Computational Economics.
  5. Smets, Frank & Wouters, Raf, 2002. "An estimated stochastic dynamic general equilibrium model of the euro area," Working Paper Series 0171, European Central Bank.
  6. Surico, Paolo, 2003. "How does the ECB target inflation?," Working Paper Series 0229, European Central Bank.
  7. Olivier Blanchard & Roberto Perotti, 2002. "An Empirical Characterization Of The Dynamic Effects Of Changes In Government Spending And Taxes On Output," The Quarterly Journal of Economics, MIT Press, vol. 117(4), pages 1329-1368, November.
  8. Robert Kollmann, 2004. "Welfare Maximizing Monetary and Fiscal Policy Rules," Computing in Economics and Finance 2004 102, Society for Computational Economics.
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