Working Paper: CEPR ID: DP4020
Authors: Roel Beetsma; Henrik Jensen
Abstract: We study optimal monetary and fiscal stabilization policy in a two-country monetary union in the presence of (inefficient) mark-up shocks, price rigidities and monopolistic competition. The underlying dynamic system contains two Phillips curves featuring public spending and mark-up shocks. We derive the second-order welfare loss approximation and characterize optimal monetary and fiscal policies under commitment and discretion. With symmetric rigidities, fiscal policy will not be employed in stabilizing union-level variables. Relative spending levels, however, are used to stabilize relative inflation rates and the terms of trade. Under commitment, both monetary policy and relative spending are inertial, while this is not the case under discretion. We conduct numerical analyses to assess the welfare gains from commitment and from having resource to fiscal stabilization. These gains are substantial. We conclude by investigating some simple monetary and fiscal policy rules. The former are based on the standard Taylor rule, while the fiscal rules link spending to output gaps. With mark-up shocks, the optimal fiscal rules are pro-cyclical. Finally, we find that welfare gains are obtained by making the rules inertial.
Keywords: commitment; discretion; markup shocks; monetary union; optimal monetary and fiscal policies; policy rules
JEL Codes: E52; E61; E63; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| monetary policy under commitment (E60) | stabilization of current forward-looking variables (E63) |
| relative fiscal policy under commitment (E62) | stabilization of current forward-looking variables (E63) |
| fiscal policy (E62) | stabilization of inflation differentials (E63) |
| fiscal policy (E62) | stabilization of terms of trade (F16) |
| commitment (D70) | gains from commitment in private consumption (D10) |
| optimal fiscal rules (E62) | fiscal policy reacts positively to output gaps (E62) |
| markup shocks (D43) | fiscal policy (E62) |
| monetary policy and fiscal policy coordination (E63) | effective management of inflationary pressures (E31) |