Monetary and Fiscal Policy Interaction in the Euro Area with Different Assumptions on the Phillips Curve

Abstract

In this paper we carry over a static version of a New Keynesian Macro Model developed in previous papers (see Bofinger, Mayer, and Wollmershauser 2002) to a monetary union. For a similar approach see (Uhlig 2002). We will show in particular that a harmonious functioning of a monetary union critically depends on the correlation of shocks that hit the currency area. Additionally a high degree of integration in product markets is advantageous for the ECB as it prevents that national real interest rates can drive a wedge between macroeconomic outcomes across member states. In particular small countries are in a vulnerable position exposed to asymmetric shocks and therefore in need for fiscal policy as an independent stabilization agent with room to breath.

Keywords: monetary policy, inflation targeting, fiscal policy, policy coordination, free-riding

JEL Classification: E50, E60, H70