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The Maastricht Criteria and Optimal Monetary and Fiscal Policy Mix for the EMU Accession Countries

  • Lipinska, Anna

The Maastricht convergence criteria set constraints on both monetary and fiscal policies in the EMU Accession Countries. This paper uses a DSGE model of a two sector small open economy with distortionary taxes to address the following question: How do the Maastricht convergence criteria modify an optimal monetary and fiscal policy mix in an economy facing domestic and external shocks? We find that targets of the unconstrained optimal monetary and fiscal policy are similar to those of the optimal monetary policy alone. The constrained policy is characterised by additional elements that penalize fluctuations of monetary and fiscal variables around the new targets which are different from the steady state of the unconstrained optimal monetary policy. Under the chosen parameterization (which aims to reflect the Czech Republic economy) the optimal monetary and fiscal policy violates three Maastricht criteria: on the CPI inflation rate, the nominal interest rate and deficit to GDP ratio. Both the stabilization component and deterministic component of the con- strained policy are different from the unconstrained optimal policy. Since monetary criteria play a dominant role in affecting the stabilization process of the constrained policy, CPI inflation and the nominal interest are characterised by a smaller variability (than under the unconstrained policy) at the expense of a higher variability of deficit to GDP ratio. The constrained policy is characterised by a deflationary bias which results in targeting the CPI inflation rate and the nominal interest rate that are lower by 1.3% (in annual terms) than the CPI inflation rate and the nominal interest rate in the countries taken as a reference. The constrained policy is also characterised by targeting surplus to GDP ratio at around 3.7%. As a result the policy constrained by the Maastricht convergence criteria induces additional welfare costs that amount to 60% of the initial deadweight loss associated with the optimal policy.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 16376.

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Date of creation: Jun 2008
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Handle: RePEc:pra:mprapa:16376
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