Independent or Coordinated? Monetary and Fiscal Policy in EMU

We examine the relations between monetary and fiscal policies in the context of a model which embodies relevant features of EMU. Our analysis suggests that, even in the absence of asymmetric shocks and of aggregate demand spillovers, EC authorities and national governments may have conflicting incentives, depending upon the relative size of demand and supply disturbances. When both aggregate demand and supply shocks are positive (negative) and the latter are large enough in absolute terms, then national governments will pursue a more expansionary (contractionary) fiscal policy than it would be desirable from a social welfare standpoint. Our results imply that, if the EC authorities are required to enforce a social welfare function defined over aggregate output and inflation, then it may be necessary to endow the EC with appropriate enforcement devices with respect to the fiscal policy stance of individual member countries. This is true even if national governments do not have an incentive to adopt a time-inconsistent behavior. Hence our conclusions support the idea that the setting of fiscal policies by member countries needs to be disciplined, and in some instances possibly over-ruled, by the EC authorities. JEL classification: E50, E61, E63, H30. Keywords