Monetary policy and fiscal discipline in the EMU: a game-theoretic analysis of the Stability Pact

In this report a formal game-theoretic framework is presented to analyse the effects of the Stability Pact on monetary policy in the EMU. First, the model shows that high deficits and government debt lead to excessive inflation, causing a rise in interest rates. Second, the analysis confirms the notion that the Stability Pact has a dampening effect on inflation, depending on the severity of the sanctions. Moreover, the analysis gives support to the much debated policy goal of 'close to balance or in surplus', concerning the deficit/GDP ratio. Finally, the model can also give insight in the relation between the economic independence of the ECB and the effectivity of the Stability Pact.