EMU and Fiscal Discipline: The End of the Depreciation Threat

Are the characteristics of the exchange rate regime relevant for the degree of fiscal discipline? What are the conclusions for fiscal behavior in Europe after the transition to EMU? These are the central questions that are analyzed in this paper from a theoretical point of view. After a general discussion of these issues, the optimization process of fiscal agents is analyzed in the context of a model based on the monetary approach to the exchange rate. The model conclusion is that monetary union leads to more fiscal discipline for high debt countries that used to have a benign neglect stance on the exchange rate. Contrasting to that, low debt countries that used to pay much attention to the exchange rate in the past will behave less disciplined in the future