Working Paper: CEPR ID: DP701
Authors: Paul Levine; Joseph Pearlman
Abstract: The paper emphasizes the distinction between the purely fiscal reasons for fiscal policy coordination under EMU (given a credible low-inflation policy by the ECB), and the spillover effects of an uncoordinated fiscal policy on monetary policy. The worst scenario is where an independent ECB sets the common interest rate and responds to a rising government debt/GDP ratio in either of the two `countries' with a looser monetary stance. The result is high inflation, high debt/GDP ratios and a large public sector. In our intermediate scenario the ECB sets the nominal interest rate and the fiscal authorities bear sole responsibility for their own solvency. The result again, is an excessively large public sector, but government debt is contained and inflation is kept low. In these first two scenarios fiscal policy coordination (with an independent ECB) is counterproductive. The best scenario occurs with credible inflation targeting by the ECB. This removes the incentive for the fiscal authorities to cause surprise inflation. Welfare gains from fiscal coordination now exist but are only substantial in a two-good EMU.
Keywords: EMU; fiscal policy coordination; monetary and fiscal policy interdependence; reputation
JEL Codes: E52; E62; F15; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Independent ECB setting common interest rate (E52) | High inflation (E31) |
| Independent ECB setting common interest rate (E52) | High debt-to-GDP ratios (H69) |
| High debt-to-GDP ratios (H69) | Excessively large public sector (H19) |
| ECB sets nominal interest rate + Fiscal authorities responsible for solvency (E52) | Excessive public sector spending (H69) |
| ECB sets nominal interest rate + Fiscal authorities responsible for solvency (E52) | Government debt contained (H63) |
| ECB sets nominal interest rate + Fiscal authorities responsible for solvency (E52) | Low inflation (E31) |
| Credible inflation targeting by ECB (E52) | Eliminates incentive for fiscal authorities to cause surprise inflation (E62) |