Fiscal Policy and Inflation in a Monetary Union

30 Pages Posted: 20 Oct 2015

See all articles by José-Miguel Cardoso-Costa

José-Miguel Cardoso-Costa

New University of Lisbon - Nova School of Business and Economics

Vivien Lewis

Research Centre; KU Leuven

Date Written: October 19, 2015

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

Suggested Citation

Cardoso-Costa, José-Miguel and Lewis, Vivien, Fiscal Policy and Inflation in a Monetary Union (October 19, 2015). Available at SSRN: https://ssrn.com/abstract=2676549 or http://dx.doi.org/10.2139/ssrn.2676549

José-Miguel Cardoso-Costa (Contact Author)

New University of Lisbon - Nova School of Business and Economics ( email )

Campus de Campolide
Lisbon, 1099-032
Portugal

Vivien Lewis

Research Centre ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

KU Leuven ( email )

Oude Markt 13
Leuven, 3000
Belgium

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