The Delors Report and the Maastricht Treaty have called for fiscal policy coordination within a European monetary union, but this remains highly controversial. In Discussion Paper No. 701, Research Fellow Paul Levine and Joseph Pearlman develop a model of a monetary union grounded in dynamic game theory. The model has two economies with identical structures that produce imperfect substitutes. There are many competitive firms and goods markets clear instantly; labour consists of a unionized sector that provides output gains from surprise inflation and a competitive sector that clears at all times. Debt neutrality is violated since households leave no anticipated bequests, the population grows exogenously, and governments finance expenditure through distortionary taxation or borrowing.

Levine and Pearlman impose a fixed nominal exchange rate and introduce a common central bank (the ECB) in one- and two-good versions of their model to assess the effects of economic integration. They compare non-cooperative and cooperative equilibria to assess the possible gains from fiscal policy coordination with an independent ECB and from full fiscal and monetary policy coordination. In their worst case the `unpleasant monetary arithmetic' the independent ECB responds to a rising national government debt/GDP ratio with a looser monetary stance, in effect monetizing the debt. This results in high inflation, high debt/GDP ratios and excessive public spending. In the intermediate case, the fiscal authorities bear sole responsibility for their own solvency, and again there is excessive public spending, but government debt and inflation are contained. In both cases, fiscal coordination is counterproductive. The best outcome occurs when credible inflation targeting by the ECB eliminates the fiscal authorities' incentive to create surprise inflation and allows welfare gains from fiscal coordination, but these are only substantial in the two-good case, in which countries still seek to improve their terms of trade.

Fiscal and Monetary Policy Under EMU: Credible Inflation Targets or Unpleasant Monetary Arithmetic?
Paul Levine and Joseph Pearlman

Discussion Paper No. 701, August 1992 (IM)