In Discussion Paper No. 1391, Research Fellow Huw Dixon and Michele Santoni construct a theoretical model that is meant to capture some of the features of economic policy coordination delemmas within the EU in a simple and stylized manner. The aim of their study is to explore the incentives for governments to cooperate by expanding expenditure. Three countries are modelled, two of which are in a monetary union (MU). Labour markets of the MU countries are unionized, and are characterized by involuntary unemployment. The general model of sequential bargaining due to Alan Manning is used to examine intra- and inter-country effects of changes in bargaining power between unions and firms.

Equilibria are determined for various bargaining regimes. The authors find interesting general equilibrium spillovers. An increase in union bargaining power over wages in a particular sector leads to a reduction in output and welfare in all sectors of both MU countries, except for those employed in that sector. An increase in union power over employment tends to increase everyone's welfare. In terms of optimal government expenditure policy, the authors find the typical cross-country demand externality of public spending, and a positive correlation between optimal expenditure levels and domestic welfare. They conclude that public spending schemes of MU countries are strategic complements and that, as a consequence, cooperation will lead to increased expenditure levels.

International Fiscal Policy Coordination with Demand Spillovers and Labour Unions
Huw David Dixon and Michele Santoni