DP639 Fiscal Policy Coordination and EMU: A Dynamic Game Approach

Author(s): Andrew Brociner, Paul L Levine
Publication Date: May 1992
Keyword(s): Barro-Ricardian Neutrality, EMU, Externality, Fiscal Policy Coordination, Reputation
JEL(s): F15, F36, F42
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=639

This paper considers fiscal policy coordination in a European Economic and Monetary Union (EMU). We use an overlapping generations model which leads to departures from Barro-Ricardian neutrality. In our calibrated model, however, we find these departures to be rather small. Two models are considered: EMU with one good; and a two-good EMU. We find that in the two-good EMU model, as relative prices can change, countries have an incentive to improve their terms of trade. This externality together with increased real interest rates - shared by all EMU countries - leads to an inefficient outcome in the non-cooperative case. Thus fiscal policy coordination can lead to significant welfare gains. With government spending externalities, however, the negative externalities can offset positive ones arising from government spending, such as defence. Furthermore, in the one-good EMU model, cooperation can be counterproductive. We conclude that the case for fiscal policy coordination depends upon the nature of both the economic integration in Europe and the externalities from government spending.