Fiscal Policy and Macroeconomic Stability within a Monetary Union

Abstract

We analyse the stability of countries within a monetary union in the face of asymmetric shocks, using a simple but widely applicable model. We show that members of the union may be subject to severe cycles following asymmetric shocks if there is a significant backward looking element in inflation behaviour. This cyclical instability can be mitigated if fiscal policy in each member country reacts to inflation differences, but it can be aggravated if fiscal feedback on debt is too strong. Although these results can only be derived analytically for a model with static consumption, numerical analysis suggest that they remain valid for a more conventional model involving intertemporally optimising consumers.

Keywords: Monetary and Fiscal Policies, Monetary Union, Macroeconomic Stability

JEL Classification: E31, E52, E58, E61,C61