DP1669 An Analysis of the 'Stability Pact'

Author(s): Roel Beetsma, Harald Uhlig
Publication Date: July 1997
Keyword(s): Debt Policy, European Monetary Union, Inflation, Monetary Policy, Political Distortions, Stability Pact
JEL(s): E58, E60, E61, E63, F33, F42, H63
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1669

We analyse the proposed ?stability pact? for countries joining a European Monetary Union (EMU). Within EMU shortsighted governments fail to fully internalize the inflationary consequences of their debt policies, which results in excessive debt accumulation. Hence, although in the absence of EMU governments have no incentive to sign a stability pact, within EMU they prefer a stability pact which punishes excessive debt accumulation. With idiosyncratic shocks to governments? budgets, EMU combined with an appropriately designed stability pact will be strictly preferred to autonomy. While the stability pact corrects the average debt bias, inflation, which is attuned to the Union-average debt level, is more stable.