Compatibility Between Monetary and Fiscal Policy Under EMU

Campbell Leith and Simon Wren-Lewis

Working Papers from Business School - Economics, University of Glasgow

Abstract: The potential importance of fiscal policy in influencing inflation has recently been highlighted, following Woodford (1998), under the heading of the ‘Fiscal Theory of the Price Level’ (FTPL). Some authors have suggested that this theory provides a rationale for the Pact for Stability and Growth as a necessary condition for the ECB pursuing a policy of price stability. In this paper, we relax the assumptions underpinning the FTPL by developing a two country open economy model, where each country has overlapping generations of non-Ricardian consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have formed a monetary union, but where the fiscal authorities remain independent. We show that the fiscal response required to ensure solvency is greater when consumers are not infinitely lived, and that although this allows for some compensating behaviour between governments, in general, both fiscal policies must remain solvent if the ECB is to aggressively target inflation. We also show that the monetary authority can abandon its active targeting of inflation to ensure the solvency of at most one fiscal authority. Any other combination of policies will either result in price level indeterminacy and/or indefinite transfers of wealth between the two economies. Finally, in a series of simulations we show that fiscal shocks have limited impact on output and inflation provided the fiscal authorities meet the (weak) requirements of fiscal solvency. However, when monetary policy is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.

Keywords: EMU; Stability and Growth Pact; Monetary Policy; Fiscal Policy; Fiscal Theory of the Price Level (search for similar items in EconPapers)
JEL-codes: E10 E63 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-eec, nep-ifn, nep-mon and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (10)

Downloads: (external link)
http://www.gla.ac.uk/media/media_22280_en.pdf (application/pdf)

Related works:
Journal Article: Compatibility between monetary and fiscal policy under EMU (2006)
Working Paper: Compatibility Between Monetary and Fiscal Policy Under EMU (2002)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:gla:glaewp:2001_15

Access Statistics for this paper

More papers in Working Papers from Business School - Economics, University of Glasgow Contact information at EDIRC.
Bibliographic data for series maintained by Business School Research Team ().