Although the Delors Report is principally concerned with monetary union, it also proposes binding constraints on national budgets, which involve the loss of sovereignty in fiscal policy. The `optimal currency area' literature, initiated by Mundell in 1961, seeks to design stabilization policy to meet shocks whose effects differ across countries. Since monetary union rules out exchange rate changes, nominal wage and price sluggishness will prevent relative prices from changing quickly in response to such shocks. Relinquishing some measure of national control over fiscal policy may provide an appropriate alternative.

In Discussion Paper No. 423, Research Fellow George Alogoskoufis identifies the conditions under which fiscal policy centralization will be superior to sovereign fiscal policy-making in a monetary union, by considering the extent to which stabilization policy objectives may be achieved efficiently with decentralized fiscal policies and their sensitivity to the nature of these shocks.

In Alogoskoufis's model, two open economies are locked into a monetary union, for which monetary policy is set by an independent central bank committed to price stability. He considers responses to relative (asymmetric) shocks to the demand for output and to productivity and also aggregate (symmetric) demand shocks, such as changes in the world interest rate. Decentralized responses to both relative and aggregate demand shocks are just as efficient as centralized, or explicitly cooperative, responses, because each country will optimally counteract such shocks directly. Employment will therefore remain unchanged, as will domestic wages and prices, so there will be no spillovers to the foreign country. Sovereign policy-making will thus achieve the first best of price and employment stability.

For productivity shocks, however, there are potential gains from fiscal policy coordination. A relative fall in productivity in one country will raise its relative prices, which will lead to relative falls in both demand and employment. With decentralized policy-making, the fiscal contraction implemented by the country hit by the adverse productivity shock in order to mitigate the rise in prices will be inefficiently small. Policy-makers do not take account of the spillovers from changes in domestic prices on prices and employment abroad, so the fiscal policies chosen will be sub-optimal. If spillovers are taken into account under cooperative fiscal policies, then the welfare losses incurred will be lower. The more efficient cooperative outcome may be achieved even with decentralized determination of fiscal policies, however, if the policy-makers in each country adopt cooperative policies as long as policy- makers in the other countries do the same, but revert to non- cooperative policies as soon as one of them defaults.

On Relative Shocks and Fiscal Policies in a Monetary Union
George S Alogoskoufis

Discussion Paper No. 423, June 1990 (IM)