Coordination of fiscal policies in a monetary union

Abstract

This paper examines how the member countries of a monetary union react to country-specific shocks and to shocks from the rest of the world, when the budget deficit is the only policy instrument available. We develop a three-country model in which countries show different preferences regarding objectives, and face asymmetric disturbances. Two of the countries form a monetary union where an independent central bank controls monetary policy, and fiscal policy is determined by fiscal authorities at the national level. In this framework, we analyse in strategic terms how authorities can deal with monetary, real and supply shocks using fiscal policy with stabilizing purposes. Finally, we discuss the welfare aspects of the optimal solution and the extent to which a coordinated fiscal policy may influence the performance and evolution of the monetary union.