Fiscal and Monetary Policy in a Monetary Union: Credible Inflation Targets or Monetised Debt?

The paper examines the interrelationship between fiscal and monetary policy in a two-country monetary union. The worst scenario occurs when an independent central bank (CB sets the nominal interest rate and responds to rising government debt/GDP ratios by monetisation. The result is high inflation, high debt/GDP ratios and a large public sector. Government debt and inflation are contained if the governments bear sole responsibility for solvency, but the public sector remains excessively large. The best scenario occurs if the CB removes the incentive for the governments to engineer surprise inflation by credible inflation targeting.