Strategic Interactions between Monetary and fiscal Policies : a case study for the European Stability Pact

We extend the model of Leith and Wren-Lewis (2000) to the case of a monetary union. Within a two-country dynamic model with wealth private behaviours, we study the implications of stabilising public debt on monetary and fiscal policies. The model is a macroeconomic version of the Fiscal Theory of the Price Level. We introduce an asymmetry in fiscal policies: one fiscal policy is ‘active’ in the short run; the other is always ‘passive’. Both policies are the outcomes of a game between the two governments and the ECB. In this framework, we assess the ‘beggar-thy-neighbour’ consequences of the passive fiscal policy in the fiscally-constrained country. Because of the inability of this government to implement an ‘active’ policy, the other government may incur a higher public debt burden. The ECB has to get more involved in the macroeconomic stabilisation process and has to prevent fiscal policy in the country with sound public finance from being too much active. The more substantial these ‘beggar-thy-neighbour’ effects, the more profitable cooperation between governments and the central bank.