Fiscal Policy and Regional Inflation in a Currency Union

FRB Richmond Working Paper No. 03-11

34 Pages Posted: 3 Dec 2012

See all articles by Margarida Duarte

Margarida Duarte

Federal Reserve Banks - Federal Reserve Bank of Richmond

Alexander L. Wolman

Federal Reserve Bank of Richmond

Date Written: August 1, 2003

Abstract

This paper investigates the ability of a region participating in a currency union to affect its inflation differential with respect to the union through fiscal policy. We study the interaction between regional fiscal policy and inflation differentials in a flexible-price, two-region model with both traded and nontraded goods. For symmetric regions, changes in one region’s tax rule that decrease the volatility of its inflation differential also decrease the volatility of its output. The decrease in the volatility of the inflation differential is brought about by an increase in the volatility of tax rates. The effect of the tax rule on output volatility – but not inflation volatility – depends on country size. For a small country lower volatility of inflation differentials is associated with higher volatility of output. This relationship results from the fact that small countries are more open, and hence there is a greater role for traded goods productivity shocks.

Keywords: currency union, fiscal policy, inflation differentials

JEL Classification: F33, F02, E62

Suggested Citation

Duarte, Margarida and Wolman, Alexander L., Fiscal Policy and Regional Inflation in a Currency Union (August 1, 2003). FRB Richmond Working Paper No. 03-11. Available at SSRN: https://ssrn.com/abstract=2184493 or http://dx.doi.org/10.2139/ssrn.2184493

Margarida Duarte (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

Alexander L. Wolman

Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

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