The Interaction of Fiscal and Monetary Policy in a Monetary Union: Balancing Credibility and Flexibility

This paper explores how decentralized, national fiscal policies interact with a common monetary policy in a monetary union. We show that fiscal policy plays a more important role in stabilizing country-specific shocks than with national monetary policies. Whereas monetary unification with an optimally designed central bank reduces both expected inflation and the variance of inflation, it harms overall welfare by reducing output and public spending and increasing the variability of these variables. However, international transfers may avoid this decline in welfare. Keywords: monetary union, stabilization, central bank conservatism, credibility, flexibility. JEL codes: E52, E58, E61, E62. November 1995 Mailing address: LIFE/Department of Economics University of Limburg P.O.Box 616 6200 MD Maastricht The Netherlands * Part of this paper was written while Beetsma was a postdoctoral fellow at DELTA (Joint Research Unit CNRS-EHESS-ENS). He thanks DELTA for the stimulating research environment.