Overturning Mundell: Fiscal Policy in a Monetary Union

Central to ongoing debates over the desirability of monetary unions is a supposed trade-off, outlined by Mundell (1961) : a monetary union reduces transactions costs but renders stabilization policy less effective. If shocks across countries are sufficiently correlated, then, according to this argument, delegating monetary policy to a single central bank is not very costly and a monetary union is desirable.
This paper explores this argument in a setting with both monetary and fiscal policies. In an economy with monetary policy alone, we confirm the presence of the trade-off and find that indeed a monetary union will not be welfare improving if the correlation of national shocks is too low. However, fiscal interventions by national governments, combined with a central bank that has the ability to commit to monetary policy, overturn these results. In equilibrium, such a monetary union will be welfare improving for any correlation of shocks.     

Financial frictions and optimal stabilization policy in a monetary union

Financial frictions differ across countries and thus cause international differences in the transmission of shocks. This paper shows how the optimal mix of monetary and fiscal policy depends on these country-specific financial frictions. To this end, we build a two-country DSGE-model of a monetary union. Financial frictions are captured by the cost channel approach. We show that the traditional solution to the assignment problem – the common central bank stabilizes the inflation rate at the union level and the national fiscal authorities stabilize the national economies – does not hold in a world with financial frictions. The cost channel decreases the efficiency of monetary policy and increases the need for fiscal stabilization even at the union level. Moreover, the more heterogeneous the union, the more important is fiscal policy in stabilizing shocks. Finally, we evaluate the scenarios in terms of welfare of the representative household.     

United we stand: on the macroeconomics of a Fiscal union

In this paper, we apply dynamic tracking games to macroeconomic policy making in a monetary union. We use a small stylized nonlinear two-country macroeconomic model of a monetary union for analyzing the interactions between two fiscal (governments: “core” and “periphery”) and one monetary (central bank) policy makers, assuming different objective functions of these decision makers. Using the OPTGAME algorithm, we calculate numerical solutions for cooperative (Pareto optimal) and non-cooperative games (feedback Nash). We show how the policy makers react to adverse demand shocks. We investigate the consequences of three scenarios: decentralized fiscal policies controlled by independent governments (the present situation), centralized fiscal policy (a fiscal union) with an independent central bank (pure fiscal union), and a fully centralized monetary and fiscal union. For the latter two scenarios, we demonstrate the importance of different assumptions about the joint objective function corresponding to different weights for the two governments in the design of the common fiscal policy. We show that a fiscal union with weights corresponding to the number of states in each of the blocs gives better results than non-cooperative policy making. When one bloc dominates the fiscal union, decentralized policies yield lower overall losses than the pure fiscal union and the monetary and fiscal union.     

Discretionary policy in a monetary union with sovereign debt

This paper examines the interactions between multiple national fiscal policymakers and a single monetary policy maker in response to shocks to government debt in some or all of the countries of a monetary union. We assume that national governments respond to excess debt in an optimal manner, but that they do not have access to a commitment technology. This implies that national fiscal policy gradually reduces debt: the lack of a commitment technology precludes a random walk in steady-state debt, but the need to maintain national competitiveness avoids excessively rapid debt reduction. If the central bank can commit, it adjusts its policies only slightly in response to higher debt, allowing national fiscal policy to undertake most of the adjustment. However, if it cannot commit, then optimal monetary policy involves using interest rates to rapidly reduce debt, with significant welfare costs. We show that in these circumstances the central bank would do better to ignore national fiscal policies in formulating its policy.     

“Core” and “Periphery” in a Monetary Union: A Macroeconomic Policy Game

We develop a dynamic game model of a two-country monetary union to study strategic interactions between macroeconomic policy makers, namely the central bank and governments. In this union, the governments of participating countries pursue national goals when deciding on fiscal policies, whereas the common central bank’s monetary policy aims at union-wide objective variables. The union considered is asymmetric, consisting of a core, with lower initial public debt, and a periphery, with higher initial public debt. For a symmetric demand shock, we derive numerical solutions of the dynamic game between the governments and the central bank using the OPTGAME algorithm. We show that mildly active cooperative countercyclical policies dominate noncooperative solutions and a scenario of no policy intervention. Optimal policies call for a brief expansionary action to bolster the effects on output and a return to a small fiscal primary surplus as soon as the crisis is over until the targeted level of public debt is reached.     

A Repeated Game Model of Monetary Union

Given a policy rule of the common central bank of a monetary union, member countries with different preferences about inflation and facing asymmetric shocks have different incentives to secure political intervention in the bank's operation and achieve the temporary benefit of surprise inflation. This is modelled as a repeated game, and the most cooperative outcome subject to the countries' incentive compatibility constraints is found. The optimal rule responds flexibly to asymmetric shocks, adjusting policy away from the full commitment level toward the discretionary level, so as to maintain the worse-hit country's incentive to abide by the rule.     

MONETARY POLICY IN EMU WITH ASYMMETRIC TRANSMISSION AND NON-TRADABLE GOODS

Which policy objective should a central bank pursue in a monetary union with asymmetric monetary transmission and different rates of inflation? Should it base its decisions on the EU‐wide average of inflation and growth or should it instead focus on (appropriately weighted) national utility losses based on national rates of inflation and growth? We find that a policy which minimises the sum of national utility losses leads to higher average utility if the variability of common shocks is large relative to idiosyncratic demand shocks in the non‐tradables sectors. We draw conclusions for the appropriate weight of common and national objectives in the union.     

Inflation in Open Economies with Complete Markets

This paper uses an overlapping generations model to analyze monetary policy in a two-country model with asymmetric shocks. Agents insure against risk through the exchange of a complete set of real securities. Each central bank is able to commit to the contingent monetary policy rule that maximizes domestic welfare. In an attempt to improve their country’s terms of trade of securities, central banks choose to commit to costly inflation in favorable states of nature. In equilibrium the effects on the terms of trade wash out, leaving both countries worse off. Countries facing asymmetric shocks may therefore gain from monetary cooperation.     

The political economy under monetary union: has the euro made a difference?

Economic and monetary union (EMU) has transformed Europe and has created an integrated pan-European economy. Much research has focused on understanding this integration process and what benefits and costs it entails. This paper identifies a political economy channel of EMU as the monetary union implies that member states had to transfer or at least curtail their policy autonomy in several areas, such as monetary policy and fiscal policy. The paper shows that EMU has helped reduce the impact of political shocks on the domestic economy of member states but magnified the transmission of political shocks within the euro area. Equally importantly, economies with weak domestic policies and institutions exhibited a significantly higher sensitivity to domestic political shocks before EMU, but not thereafter. While this may entail that EMU has brought benefits to countries with weaker policies and institutions by insulating them from adverse political developments at home, a potential drawback is that it may provide weaker market discipline for domestic political stability.
— Marcel Fratzscher and Livio Stracca     

“Haircuts” for the EMU periphery: virtue or vice?

We use a dynamic game model of a two-country monetary union to study the impacts of an exogenous fall in aggregate demand, the resulting increase in public debt, and the consequences of a sovereign debt haircut for a member country or bloc of the union. Two different scenarios for such a haircut are assumed: an expected and an unexpected haircut. In the union, the governments of participating countries pursue national goals when deciding on fiscal policies whereas the common central bank’s monetary policy aims at union-wide objective variables. The union considered is asymmetric, consisting of a “core” with lower initial public debt, and a “periphery” with higher initial public debt. The “periphery’’ may experience the haircut due to the high level of its sovereign debt. We calculate numerical solutions of the dynamic game between the governments and the central bank using the OPTGAME algorithm. We show that a haircut as modeled in our study is disadvantageous for both the “core” and the “periphery” of the monetary union, both when expected and when unexpected.     

A simulation study of an ASEAN monetary union

This paper analyzes some pros and cons of a monetary union for the ASEAN¹ countries, excluding Myanmar. We estimate a stylized open-economy dynamic general equilibrium model for the ASEAN countries. Using the framework of linear quadratic differential games, we contrast the potential gains or losses for these countries due to economic shocks, in case they maintain their status-quo, they coordinate their monetary and/or fiscal policies, or form a monetary union. Assuming for all players open-loop information, we conclude that there are substantial gains from cooperation of monetary authorities. We also find that whether a monetary union improves upon monetary cooperation depends on the type of shocks and the extent of fiscal policy cooperation. Results are based both on a theoretical study of the structure of the estimated model and a simulation study.     

HETEROGENEITY IN A CURRENCY UNION WITH SOCIAL MARKET OBJECTIVES

In this paper, we explore whether heterogeneity among union members could threaten the stability of the European Monetary Union. The types of heterogeneity we consider are (1) asymmetries in the transmission of monetary and fiscal policies, and (2) differences in national preferences for price stability, output growth, and income redistribution. Our results show that the costs of membership can be significant for countries whose transmissions, structure, or preferences deviate from those underlying the common monetary policy. In part, these costs arise because monetary policy imposed by an independent central bank automatically constrains the use of fiscal policy by national governments.     

On the Institutional Design of the European Monetary Union: Conservatism, Stability Pact and Economic Shocks

The aim of this paper is to design the optimal institutional arrangement for a monetary union. Using a two-country rational expectations model, the study analyses how the conservatism of the area-wide central bank and the penalty system for fiscal deviation (Stability and Growth Pact) should be designed with respect to different economic shocks. The optimal institutional arrangement is also dependent on who is the 'leader' of the policy game. When national governments move first, the independent area-wide central bank can exercise greater discipline over national fiscal policies, making the Stability Pact unnecessary.
(J.E.L.: E58, E63, F42).     

Central bank independence,fiscal deficits and currency union: Lessons from Africa

Can central bank independence (CBI) help to reduce fiscal balances? In this paper, we answer this question using novel measures of CBI based on the turnover rate of central bank governors (TOR) and the Garriga measure of legal independence for 30 African countries for the period 1990–2017. Our novel measures of CBI capture the degree of alliance between the fiscal authority and the monetary authority which can potentially lead to debt monetization and higher fiscal balances. Thus, we classify central bank governor changes into ally changes or non-ally changes; in addition to that, we decompose our full sample into CFA zone countries and non-CFA zone countries to capture the effect of currency union membership. Our results show that for CFA zone countries, central bank autonomy, when proxied by the turnover rate of central bank governors, is associated with a decrease in fiscal balances and replacing a central banker with a non-ally, is negatively and significantly associated with fiscal balances.     

The optimality of a gulf currency union: Commonalities and idiosyncrasies

A high degree of shared national elements that drive the bulk of observed output volatility between countries is generally seen as a necessary prerequisite for the formation of a successful monetary union. This is because countries in a monetary union accept a one-size-fits all, resigning regions to policies that are based on some aggregate macroeconomic target rather than a country-specific one. For this reason, the cost of monetary union membership depends on the incidence of asymmetric (nation-specific) shocks rather than symmetric, or common shocks. This criteria is examined for the Gulf Cooperation Council (GCC) countries, who reaffirmed plans for the implementation of a single currency. This paper quantifies, using structural factor models with common factor restrictions, changes in output synchronisation, the importance of common factor or idiosyncratic shocks between the regions, and the synchronisation of these shocks across the GCC as well as the implications for GCC-wide macroeconomic policy at short-to-medium term horizons. Despite current difficulties in fulfilling the convergence criteria goals to monetary union, the results show the synchronisation of output growth fluctuations between economies of the GCC to have increased over the past 25 years. This paper also finds that a fairly sizeable proportion of output fluctuations in business cycle frequencies are driven by a common component that, to some degree, reflects U.S. monetary policy and U.S. demand shocks as well as changes in crude oil prices.     

Budget uncertainty in a monetary union

Governments in a monetary union fear spending disturbances. We distinguish them according to their ability to hedge against these disturbances and assume that they derive their optimal fiscal decisions by using a robust control approach. Results show that governments being highly vulnerable to spending disturbances set excessive tax rates, thereby exacerbating the fiscal pressure detrimental to output and obliging the central bank to conduct an expansionary monetary policy. Countries whose governments have higher ability to hedge against spending disturbances then suffer from the inflationary consequences of this monetary policy.     

EMU in Reality: The Effect of a Common Monetary Policy on Economies with Different Transmission Mechanisms

The theory of optimal currency areas states that a single currency zone should have symmetry of shocks and structures across regions. Research on monetary union in Europe has either assumed these conditions to hold close enough not to cause problems, or has focussed on asymmetries in shocks. But what if economic structures and/or market responses differ between countries or regions? This paper examines the consequences of a single monetary policy when there are asymmetries in i) the monetary transmissions; ii) the wage/price transmissions; and iii) private sector asset holdings. We find the first and last destabilise the business cycle, and put countries out of phase with one another in a way that cannot be corrected by deficit constrained fiscal policies. The effect is to delay convergence.     

Macroeconomic Stabilization in the EMU: Rules Versus Institutions

This paper investigates the macroeconomic implications of different regimes of international fiscal coordination and monetary‐fiscal cooperation in a monetary union with independent fiscal authorities, that act strategically vis‐à‐vis a common central bank. In the presence of other policy goals than cyclical stabilization, such as interest rate smoothing and fiscal stability, we show that coordination among national fiscal authorities can reduce output and inflation volatility relative to the non‐cooperative setting in specific circumstances, as in case of demand disturbances, while turning potentially counterproductive otherwise. The adverse effects of union‐wide coordinated fiscal measures can be attenuated in a regime of global coordination, namely, when a centralized fiscal stabilization is coordinated with the common monetary policy as well.     

Compatibility between monetary and fiscal policy under EMU

The debate over the Stability and Growth Pact (SGP) as a part of European Monetary Union, has highlighted the need to assess the extent to which fiscal policies of union members should be constrained as a pre-requisite for price stability within the union. In this paper, we develop a two country open economy model, where each country has overlapping generations of finitely lived 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 stability of the real debt stock is greater when consumers are not infinitely lived. In principle, this allows for some compensating behaviour between governments, but we show that the scope for compensation is limited. The monetary authority can abandon its active targeting of inflation to stabilise the debt of at most one fiscal authority, and 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.     

Fiscal risk in a monetary union

We present a dynamic and quantitative model of a fiscal solvency crisis in a monetary union. Diverse fiscal policies, which are subject to fiscal limits and stochastic shocks, can threaten a monetary union. The fiscal limits arise due to distortionary taxation and political will. Stochastic shocks are random and could push a fiscally sound policy towards its limit. In equilibrium agents refuse to lend along a path which violates the fiscal limits, creating a fiscal solvency crisis. The dynamics leading to the crisis depend on the policy response to restore lending. We focus on two responses, default and policy switching. We simulate our model to quantify the probability of a fiscal solvency crisis in the European Monetary Union with fiscal variables at end of 2009 values. Our model predicts the Greek crisis which occurred and warns of an Italian one.