Regional Inflation in a Currency Union: Fiscal Policy vs. Fundamentals

43 Pages Posted: 17 May 2003

See all articles by Margarida Duarte

Margarida Duarte

University of Toronto - Department of Economics

Alexander L. Wolman

Federal Reserve Bank of Richmond

Date Written: September 2002

Abstract

We develop a general equilibrium model of a two-region currency union. There are two types of goods: Non-traded goods, and traded goods for which markets are segmented. Monetary policy is set by a central monetary authority and is non-neutral due to nominal price rigidities. Fiscal policy is determined at the regional level by each region's government. We find that productivity shocks alone generate significant variation in inflation across the two countries. Government spending shocks, in contrast, do not account for a significant portion of inflation variation. Varying relative country size, we find that smaller countries experience higher variability of their inflation differential in response to shocks to productivity growth. Moreover, we show that regional governments can suppress incipient inflation differentials associated with shocks to productivity growth by letting the income tax rate respond negatively to inflation differentials.

Keywords: Currency union, fiscal policy, inflation differentials, productivity differentials, nominal rigidities

JEL Classification: E31, E32, F41, H63

Suggested Citation

Duarte, Margarida P. and Wolman, Alexander L., Regional Inflation in a Currency Union: Fiscal Policy vs. Fundamentals (September 2002). ECB Working Paper No. 180; FRB International Finance Discussion Paper No. 746. Available at SSRN: https://ssrn.com/abstract=358182

Margarida P. Duarte

University of Toronto - Department of Economics ( email )

150 St. George Street
Toronto, Ontario M5S 3G7
Canada

Alexander L. Wolman (Contact Author)

Federal Reserve Bank of Richmond ( email )

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

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