Compatability between Monetary and Fiscal Policy Under Emu

U of Glasgow Economics Working Paper No. 01-15

36 Pages Posted: 4 Mar 2003

See all articles by Campbell Leith

Campbell Leith

University of Glasgow - Department of Economics

Simon Wren-Lewis

University of Oxford - Economics Department

Date Written: 2001

Abstract

The potential importance of fiscal policy in influencing inflation has recently been highlighted, following Woodford (1995), under the heading of the 'Fiscal Theory of the Price Level' (FTPL). Some authors have suggested that this theory provides a rationale for the Pact for Stability and Growth as a necessary condition for the ECB pursuing a policy of price stability. In this paper, we relax the assumptions underpinning the FTPL by developing a two country open economy model, where each country has overlapping generations of non-Ricardian 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 small 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.

Keywords: EMU, Stability and Growth Pact, Monetary Policy, Fiscal Policy, Fiscal Theory of the Price Level

JEL Classification: E10, E63

Suggested Citation

Leith, Campbell and Wren-Lewis, Simon J.Q., Compatability between Monetary and Fiscal Policy Under Emu (2001). U of Glasgow Economics Working Paper No. 01-15, Available at SSRN: https://ssrn.com/abstract=355022 or http://dx.doi.org/10.2139/ssrn.355022

Campbell Leith (Contact Author)

University of Glasgow - Department of Economics ( email )

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Simon J.Q. Wren-Lewis

University of Oxford - Economics Department ( email )

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Oxford, OX1 3BJ
United Kingdom

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