Fiscal policy coordination in a European monetary union may help to prevent member countries' public sector deficits from raising real interest rates and crowding out investment in other countries, to prevent national governments from seeking to improve their terms of trade through `beggar-thy-neighbour' fiscal expansions, and to reap the positive externalities that may arise from certain components of government spending such as defence.

In Discussion Paper No. 639, Andrew Brociner and Research Fellow Paul Levine develop an overlapping generations model in which consumers maximize intertemporal utility and firms maximize intertemporal profits. This departs from Barro-Ricardian neutrality since individuals leave no anticipated bequests and the population is growing. For two countries with irrevocably fixed nominal exchange rates and a common nominal interest rate set by the European Central Bank (ECB), which pursues a credible low-inflation policy, they apply their dynamic game model to two cases: EMU1, with one good only, and EMU2, in which each country specializes in producing its home good. They examine the case for cooperation where both authorities lack reputation, using the case in which both policy-makers enjoy a reputation for precommitment as the optimal bench-mark.

They conduct simulations in which governments' solvency is ensured by a taxation stabilization rule under which the previous period's debt/GDP ratio feeds back into the current period's taxes. Under EMU2, relative prices can change, which provides countries with an incentive to improve their terms of trade, which together with the increased real interest rates in both countries leads to an inefficient outcome in the non- cooperative case. Fiscal policy coordination can therefore lead to significant welfare gains, while government spending may entail negative externalities that will offset its positive effects.

Under EMU1, however, relative prices remain constant, so there can be no terms-of-trade effect. Without cooperation, government spending falls and induces a smaller welfare loss than under cooperation, which may therefore be counterproductive. Brociner and Levine therefore conclude that the case for fiscal policy coordination depends on the nature of Europe's economic integration and the externalities that arise from government spending.

Fiscal Policy Coordination and EMU: A Dynamic Game Approach
Andrew Brociner and Paul Levine

Discussion Paper No. 639, May 1992 (IM)