DP11780 Fiscal policy coordination in currency unions at the effective lower bound

Author(s): Thomas Hettig, Gernot Müller
Publication Date: January 2017
Keyword(s): coordination, Currency Union, effective lower bound, EMU, Fiscal policy, optimal policy, terms-of-trade externality
JEL(s): E61, E62, F41
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11780

According to the pre-crises consensus there are separate domains for monetary and fiscal stabilization in a currency union. While the common monetary policy takes care of union-wide fluctuations, fiscal policies should be tailored to meet country-specific conditions. This separation is no longer optimal, however, if monetary policy is constrained by an effective lower bound on interest rates. Specifically, we show that in this case there are benefits from coordinating fiscal policies across countries. By coordinating on a common fiscal stance, policy makers are able to stabilize union-wide activity and inflation while avoiding detrimental movements of a country's terms of trade.