It is controversial whether a European monetary union will strengthen or weaken member governments' incentives to adopt `reasonable' fiscal policies. But what is `fiscal discipline'? What sorts of rules might be imposed on the fiscal policy independence of national governments? How could we specify a Community-wide fiscal policy?

In Discussion Paper No. 488, Research Fellow Charles Wyplosz examines how a monetary union's existence affects national governments' trade-offs in setting fiscal policies and the externalities a country's policies impose on its partners. While a temporary national fiscal expansion that boosts demand also raises the interest rate, a permanent expansion has ambiguous effects. Similarly, temporary fiscal actions improve the terms of trade, while permanent actions have ambiguous effects. Introducing a monetary union forces real exchange rates to be equal and pushes terms-of-trade changes onto prices, so fiscal effects on interest rates can no longer be `bottled-up' in their country of origin: they are absorbed instead by union-wide interest rate changes. Terms-of-trade effects substitute for interest rate effects: therefore they are larger and adjust more rapidly under a union than under flexible exchange rates.

So long as currencies differ, real interest rates can differ by the expected real depreciation, and the real interest rate of a country undertaking a fiscal expansion (that is not money financed) may increase, since immediate exchange rate appreciation generates the expectation of depreciation in the future. In a monetary union, however, nominal and real interest rates must be equal, at least over the longer run, which increases the likelihood of a country-specific increase in public bond rates, implying a tighter budget constraint. In contrast, when the option of monetization exists, a fiscal expansion leads to inflation, depreciation and a terms-of-trade loss in a flexible exchange rate regime, but it will affect the whole union equally. Fiscal laxity can be avoided by agreeing on rules for money creation, while leaving national authorities free to set domestic fiscal policies.

Fiscal policy discipline under a monetary union may require that a country adopt a policy that is sub-optimal from its own viewpoint. Since the first-best solution policy coordination is hard to design and implement in practice, two possible alternatives emerge: to reject all attempts to establish union-wide fiscal policy rules, opting instead for more flexible forms of coordination such as surveillance; or full policy coordination, as occurs within a Federal budget. The extremes seem to dominate the intermediate alternatives.

Monetary Union and Fiscal Policy Discipline
Charles Wyplosz