Macroeconomic Policy Interactions in the EMU: A Case for Fiscal Policy Co-ordination

We analyse the effects of fiscal policy co-ordination in a monetary union on inflation, public expenditure and the optimal degree of conservatism of the central bank. Our main result is that, when the fiscal authorities internalise the spillover effects originating from their loose fiscal stances, monetary policy commitment problems are mitigated. As a result, the optimal degree of conservatism of the central bank declines. Moreover, we show that the Stability Pact can be seen as an optimally designed linear penalty in the utility function of the fiscal authorities. This is able to achieve the same desired result as fiscal policy co-ordination but without an explicit commitment to it.