Understanding the Rationale of the Stability and Growth Pact. ACES Cases No. 2007.2

This paper investigates the rationales for fiscal rules in a monetary union, such as the Stability and Growth Pact (SGP), which has been adopted in the European Union (EU). Rationales for rules in fiscal policy have been found linked to the existence of externalities in a monetary union, which affect the common monetary policy and thus other countries in the currency union, as well as to the problems emerging from the political nature of the framework in which fiscal policy needs to be decided. Together, these comprise solid reasons for the creation of a fiscal rule in a monetary union. The main inconvenience of creating such a rule is, however, the loss of an independent fiscal policy for any individual economy within a currency union. Even taking this drawback into account, a crucial argument for the creation of the SGP regards the benefits and effectiveness of automatic stabilization and currency strength. On this point, a consensus has been reached, but scholars have not yet achieved wide agreement on the Pact’s effectiveness when economies face different types of shocks.