Fiscal Policy and Inflation in a Monetary Union

Abstract

This paper studies optimal fiscal policies in a small open economy within a monetary union. The government has access to nominal non-state contingent debt and distortionary labour taxes to finance exogenous spending. Price levels differ across countries due to consumption home bias; thus fiscal policy influences inflation and the terms of trade. Prices are flexible. We show that, unlike in a country with an independent monetary policy, some variability in labour taxes is optimal. This is true even when the terms-of-trade externality is shut down. While fiscal policy aims at smoothing production distortions, with nominal public debt there is an incentive to use taxes to inflate in bad times when debt levels are high, reminiscent of Chari et al's (1991) optimal monetary policy result.

Keywords: optimal fiscal policy, inflation, monetary union, small open economy, non-state-contingent debt

JEL Classification: E62, E31, F41