Fiscal constraints and incentives with monetary coordination: implications for Europe 1992

This paper analyzes how the feasible mix of government expenditure and financing arrangements may change in a monetary union such as that presently under discussion for the European Community. The effect of this institutional change on the incentives facing fiscal policymakers in their budgetary decisions also is investigated. The framework of analysis is a two-country, two-period intertemporal framework with maximizing private and public sector behavior. We find that the range of feasible divergence in the present discounted value of fiscal spending is reduced in a monetary union, although differences across countries in the time pattern of spending between present and future periods are possible. We also find that as a monetary union constrains countries to similar rates of money growth and debt monetization, it provides an incentive for countries to converge in their fiscal positions. We conclude that greater convergence in fiscal positions among EC countries than heretofore may be desirable to assure the success of a monetary union, and that an incentive toward budgetary convergence is likely to be created by the change in institutional monetary arrangements itself.