DP5584 Fiscal Policy and Macroeconomic Stability Within a Currency Union

Author(s): Tatiana Kirsanova, David Vines, Simon Wren-Lewis
Publication Date: March 2006
Keyword(s): macroeconomic stability, monetary and fiscal policies, monetary union
JEL(s): E52, E61, E63, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5584

We analyse the stability of countries within a monetary union in the face of asymmetric shocks, using a simple but widely applicable model. We show that members of the union may be subject to severe, and possibly unstable, cycles following asymmetric shocks if there is a significant backward looking element in inflation behaviour, and if real interest rates influence the level of aggregate demand. This cyclical instability can be mitigated if fiscal policy in each member country reacts to inflation differences, but it can be aggravated if fiscal feedback on debt is too strong.