Strategic Interactions Among Central Bank and National Fiscal Authorities in a Monetary Union Subject to Asymmetric Country Shocks

In this paper we extend Nordhaus’ (Brookings Pap Econ Act (2):139–199, 1994) results to an environment which may represent the current European situation, characterised by a single monetary authority and several fiscal bodies. We show that, even assuming that the monetary and the fiscal authorities share the same ideal targets, in the presence of asymmetric shocks the “symbiosis” result found by Dixit and Lambertini (J Int Econ 60:235–247, 2003) no longer obtains. Thus, fiscal rules as those envisaged in the Maastricht Treaty and in the Stability and Growth Pact may work as monetary/fiscal coordination devices that improve welfare. The imposition of common targets, however, may work as a substitute for policy coordination only if these are made state contingent, an aspect that the recent version of the Stability and Growth Pact takes into account in a more appropriate way than its original version.

Fiscal Policy and Macroeconomic Stabilizations: What are the Gains from Cooperation?

In this paper we extend the open-economy stochastic framework of Obstfeld and Rogoff (Q J Econ. 117:503–36, 2002) to include distortionary taxation, when prices are flexible but wages are sticky. We use the model to analyze the optimal design of tax rules that respond to productivity shocks, under non-cooperation and cooperation between the fiscal authorities, and evaluate the gains from coordination. We show that, although monetary policy would be preferred to fiscal policy as a stabilization tool both under competition (Nash) and under cooperation, there is a role for procyclical fiscal stabilization in a monetary union where the monetary authority cannot respond to asymmetric shocks. Moreover, we show that in the Nash game there will be an incentive for the fiscal authorities to try to manipulate the terms-of-trade in their favor, and we estimate the potential gains from fiscal policy coordination. The size of the gains depends crucially on the value of the Frisch elasticity of labor supply. For lower values of the Frisch elasticity (more in line with microeconometric estimates) the gains are relatively small, but for more elastic labor supplies (more in agreement with the business cycle literature) the gains can be very large.

Monetary and Fiscal Policy Interaction in the Euro Area with Different Assumptions on the Phillips Curve

In this paper we apply a static version of a New Keynesian macromodel to a monetary union (see Bofinger et al., J Econ Educ, 37:98–117 (2006), Walsh, J Econ Educ, 33:333–346 (2002)). We show in particular that a harmonious functioning of a monetary union critically depends on the correlation of shocks that hit the currency area. Additionally a high degree of integration in product markets is advantageous for the ECB as it prevents national interest rates from driving a wedge between macroeconomic outcomes across member states. In particular small countries are in need for fiscal policy as an independent stabilization agent with room to breath.

Fiscal policy in central and Eastern Europe: what happened in the run-up to EU accession?

This paper analyses the evolution of fiscal policy in central and eastern European countries during the EU accession process, testing for country and time specific effects. This is done by constructing Taylor-type policy rules and by calculating three measures of fiscal stance. A key finding is that the differences across countries are more significant than those across time. Baltic countries tended to have had tighter fiscal policy which responded to the output gap, larger central European countries had more lax (and increasingly lax) fiscal policies which were unresponsive to the output gap. These differences correlate closely with cross-country differences in exchange rate regimes and no link is found to either spending composition or political variables. Taken together the results suggest that the exchange rate regime is by far the most significant determinant of fiscal performance. These results suggest that the “soft power” of the prospect of EU entry did not act as a spur to greater fiscal discipline and that higher budget deficits in recent years cannot be blamed on costs of accession.

Reforms,Exchange Rates and Monetary Commitment: A Panel Analysis for OECD Countries

The paper investigates the link between monetary policy and structural reforms in open economies. We test three hypotheses: (a) the Calmfors hypothesis that the degree of reforms is higher in the case of autonomous policy and lower in the case of commitment, (b) the TINA hypothesis which implies a positive impact of a monetary policy rule on the extent of reforms, and (c) a third factors hypothesis. In our empirical analysis on panel data of 23 OECD countries from 1980–2000 we find little evidence for the Calmfors hypothesis, but evidence in favor of the TINA argument for labor market and regulatory reform.

Asset Prices as Indicators of Euro Area Monetary Policy: An Empirical Assessment of Their Role in a Taylor Rule

This paper estimates forward-looking and forecast-based Taylor rules for France, Germany, Italy, and the euro area. Performing extensive tests for over-identifying restrictions and instrument relevance, we find that asset prices can be highly relevant as instruments in policy rules. While asset prices improve Taylor rule estimates, different assets prove most relevant across countries and this result could be seen as complicating the tasks of the European Central Bank. Encompassing tests show that forecast-based outperform forward-looking Taylor rules. A policy implication is that central banks ought to release their own forecasts and the basis upon which they are generated.

Exchange Rate Pegs, Fiscal Policy and Credibility

In a fixed exchange rate regime, an exchange rate change can be a swift way to change the real exchange rate in the short run. Fiscal policy also affects relative prices, and fiscal policy response to various types of shocks can therefore be crucial for the credibility of an exchange rate peg. We develop a model within which fiscal policy plays a crucial role for ensuring the viability and thus credibility of an exchange rate peg. We use the insights of this model to take a closer look at Denmark, which has successfully pursued a fixed exchange rate policy since 1982.

Fiscal policy and direct crowding-out in a small open economy

This paper analyses the welfare effects of fiscal policy in a small open economy, where private and government consumption are substitutes in terms of private utility. The main findings are as follows: fiscal policy raises output, bringing it closer to its efficient level, but is not welfare-improving even though government spending directly affects private utility. The main reason for this is that the introduction of useful government spending implies a larger crowding-out effect on private consumption, when compared with the ‘pure waste’ case. Utility decreases since one unit of government consumption yields less utility than one unit of private consumption. In any case, the marginal rate of substitution between private and government consumption is a key parameter in governing the welfare effects of fiscal policy.

Public Spending Management and Macroeconomic Interdependence

This paper studies the domestic and international effects of “public competition policies” aimed at improving the efficiency of public spending. Such measures are modeled as an increase in the price elasticity of public consumption. The paper finds that public competition policies significantly affect macroeconomic interdependence across countries, both through the impact of the international elasticity of substitution and of mark-up effects. The paper also develops an extension in which fiscal shocks are stochastic. In welfare terms, countries with a larger government sector have an incentive to promote global public competition policies regardless of whether fiscal policy is modeled as deterministic or stochastic.

Saving–investment Correlations in Response to Monetary Policy Shocks: New Insights into the Feldstein–Horioka Puzzle?

In this paper, it is argued that the observed high positive correlation between national savings and investment which is found in the data can in part be explained by shocks to monetary policy. This hypothesis, which is established by reviewing some empirical findings, is tested in a two-country DSGE-model framework in the tradition of the New Open Economy Macroeconomics. The simulation results obtained support the idea that shocks to monetary policy might contribute to the explanation of the Feldstein-Horioka puzzle.

Monetary Policy in Illiquid Markets: Options for a Small Open Economy

Two impediments to effective monetary policy operation include illiquidity in bond markets and the zero bound of interest rates. Under these conditions alternative means of enacting monetary policy may be required. This paper empirically explores policy options implemented through equity and currency markets that will generate similar inflation responses at different time horizons. In terms of GDP loss the least costly means of achieving a particular long run inflation outcome is via the current monetary policy arrangements. Currency market alternatives are volatile but less expensive than the equity market in terms of output loss for short term inflation horizons.

Analysis of a monetary union enlargement in the framework of linear-quadratic differential games

This paper studies the effects of a monetary union enlargement using the techniques and outcomes from an extensive research project on macroeconomic policy coordination in the EMU. Our approach is characterized by two main pillars: (i) linear-quadratic differential games to capture externalities, spillovers and strategic behaviour of (fiscal and monetary) players; and (ii) endogenous coalition formation concepts which enable us to study a creation and stability of different cooperation arrangements. In this paper we focus on the first pillar and construct a multi-player linear-quadratic continuous-time model of 5 countries and 4 central banks to evaluate effects of accession of a new member to an existing MU. Our findings stress the importance of an asymmetric shock confirming basic results of the OCA theory. It comes out that in our setting it is never profitable to enlarge the monetary union when there is a risk of an asymmetric shock. What is more, the potential losses from accession are so high that it can be barely possible to design a transfer system to compensate for a worse situation of some countries.

Devaluation,Debt, and Default in Emerging Economies

We explore the interactions between exchange rate and fiscal policy, and default on external debt. Exchange rate policy affects the supply of short-term debt facing the government. Under a conventional soft peg, it can be optimal for the government to set the exchange rate at a level in which partial default occurs. In this case multiple equilibria exist, with one featuring high interest rate, overvalued exchange rate, low level of output, and default. Default is also an equilibrium under a hard peg, precisely because devaluation is not an option. Under a hard peg, however, there is a unique equilibrium.

The Costs of Increasing Transparency

In their seminal paper, Morris and Shin (Amer Econ Rev 92(5): 1521–1534, 2002a) argued that increasing the precision of public information is not always beneficial to social welfare. Svensson (Amer Econ Rev 96: 448–451, 2006) however has disputed this by saying that although feasible, the conditions for which this was true, were not all that likely. In that respect, therefore, increasing ‘transparency’ remains most of the times beneficial to social welfare. In this paper, we extend the Morris and Shin attempt by setting it up as an explicit interactive game between the Central Bank, the objectives of which we model explicitly, and the private sector. We show that in the absence of costs, both players benefit from transparency in the manner described previously in the literature, and point the differences in their gains. Following that, we then introduce the fact that increasing transparency comes at some costs and show how both players face incentives to free ride on each other as a result. The presence of costs thus alters the way in which greater transparency is attained.

International Financial Aggregation and Index Number Theory: A Chronological Half-century Empirical Overview

This paper comprises a survey of a half century of research on international monetary aggregate data. We argue that since monetary assets began yielding interest, the simple sum monetary aggregates have had no foundations in economic theory and have sequentially produced one source of misunderstanding after another. The bad data produced by simple sum aggregation have contaminated research in monetary economics, have resulted in needless “paradoxes,” and have produced decades of misunderstandings in international monetary economics research and policy. While better data, based correctly on index number theory and aggregation theory, now exist, the official central bank data most commonly used have not improved in most parts of the world. While aggregation theoretic monetary aggregates exist for internal use at the European Central Bank, the Bank of Japan, and many other central banks throughout the world, the only central banks that currently make aggregation theoretic monetary aggregates available to the public are the Bank of England and the St. Louis Federal Reserve Bank. No other area of economics has been so seriously damaged by data unrelated to valid index number and aggregation theory. In this paper we chronologically review the past research in this area and connect the data errors with the resulting policy and inference errors. Future research on monetary aggregation and policy can most advantageously focus on extensions to exchange rate risk and its implications for multilateral aggregation over monetary asset portfolios containing assets denominated in more than one currency. The relevant theory for multilateral aggregation with exchange rate risk has been derived by Barnett (J Econom 136(2):457–482, 2007) and Barnett and Wu (Ann Finance 1:35–50, 2005).

Policy coordination in East Asia and across the Pacific

In this paper, we construct a macro-econometric model that describes the economic activity in the Asia-Pacific area and provide quantitative insights into the recent policy debates on monetary and currency coordination among the East Asian economies. The model includes a wide variety of monetary and currency policy rules that the East Asian economies adopt and allows for one country's policymaking to have substantial effects on foreign countries. We apply the model to three current policy issues: (1) the desirability of currency basket pegs in East Asia, (2) the anticipated effects of China's currency policy reform, and (3) the non-negativity constraint on Japanese nominal interest rates. The simulation analyses show the external economy effects of policy rules quantitatively and suggest the difficulty of monetary and currency policy coordination among the East Asian economies.

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Non-Keynesian Fiscal Adjustments? A Close Look at Expansionary Fiscal Consolidations in the EU

This paper analyses the characteristics of episodes of fiscal consolidation in the EU exhibiting non-Keynesian features, i.e., followed by an improved growth performance. Roughly half of the episodes of fiscal consolidations that have been undertaken in the EU in the last 30 years have been followed by higher growth. Probit regressions indicate that the consolidations that turned out to be expansionary were more likely started in periods with output below potential and based on expenditure cuts rather than on tax increases. These results appear quite robust with respect to the criteria used to identify the consolidation episodes and to classify such episodes as expansionary.

Monetary Policy Analysis in a Small Open Credit-Based Economy

This paper describes a simple framework for monetary policy analysis in a small open economy where bank credit is the only source of external finance. At the heart of the model is the link between banks’ lending rates (which incorporate a premium over and above the marginal cost of borrowing) and firms’ net worth. In contrast to models in the Stiglitz-Weiss or Kiyotaki-Moore tradition, the supply of bank loans is perfectly elastic at the prevailing rate. The central bank sets the refinance rate and provides unlimited access to liquidity at that rate. The model is used to study the effects of changes in official interest rates, under both fixed and flexible exchange rates. Various extensions are also discussed, including income effects, the cost channel, the role of land as collateral, and dollarization.

Euro-Area Inflation: does the Balassa–Samuelson effect matter?

The paper argues that the Balassa–Samuelson effect is of little importance for the inflation target of the ECB. First, econometric tests of the Balassa–Samuelson effect suggest that the most robust link is found between relative sectoral deflators and relative unit labour costs; i.e. a link that accounts for an incomplete wage pass-through. For the (change in the) HICP — the target of the ECB — and its components additional factors seem to cause divergent international and sectoral developments. Second, countries with high productivity growth in industry may experience a real devaluation in the sector of tradable goods which counters the real appreciation resulting from a relative increase in service prices. It follows that the difference in productivity growth and thus the difference in the size of the relative price adjustment between countries does not have unambiguous consequences for the overall inflation rate, and as such can thus not justify an inflation target well above zero.