Working Paper: NBER ID: w11815
Authors: Jordi Gali; Tommaso Monacelli
Abstract: We lay out a tractable model for fiscal and monetary policy analysis in a currency union, and analyze its implications for the optimal design of such policies. Monetary policy is conducted by a common central bank, which sets the interest rate for the union as a whole. Fiscal policy is implemented at the country level, through the choice of government spending level. The model incorporates country-specific shocks and nominal rigidities. Under our assumptions, the optimal monetary policy requires that inflation be stabilized at the union level. On the other hand, the relinquishment of an independent monetary policy, coupled with nominal price rigidities, generates a stabilization role for fiscal policy, one beyond the efficient provision of public goods. Interestingly, the stabilizing role for fiscal policy is shown to be desirable not only from the viewpoint of each individual country, but also from that of the union as a whole. In addition, our paper offers some insights on two aspects of policy design in currency unions: (i) the conditions for equilibrium determinacy and (ii) the effects of exogenous government spending variations.
Keywords: Monetary Policy; Fiscal Policy; Currency Union; Nominal Rigidities; Economic Stability
JEL Codes: E52; F41; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fiscal policy actions (E62) | impacts on inflation and output within the currency union (F36) |
| optimal monetary policy (E63) | inflation stabilization at the union level (E31) |
| relinquishment of independent monetary policy (E58) | stabilization role for fiscal policy (E63) |
| national fiscal authorities implement optimal policies (E63) | central bank maintains inflation targeting effectively (E52) |
| if national fiscal responses are not coordinated (F42) | central bank deviates from strict inflation targeting (E52) |
| each country's fiscal authority provides public goods and stabilizes domestic inflation and output gaps (O23) | enhances overall economic stability for the union (F36) |
| coordinated fiscal policies (F42) | enhance overall economic stability (E60) |