Fiscal Policy in the European Monetary Union

Abstract

A country entering the EMU surrenders its monetary policy, and its debt becomes denominated in terms of a currency over which it has no direct control. A country's promise to uphold the …scal limits in the Maastricht Treaty and the Stability and Growth Pact is implicitly a promise not to allow its …scal stance to deteriorate to a position in which it places pressure on the central bank to forgo its price level target to …nance …scal de…cits. Violation of these limits has raised questions about potential …scal encroachment on the monetary authority's freedom to determine the price level. We specify a simple model of …scal policy in which the …scal authority faces an upper bound on the size of its primary surplus. Policy is determined by a …scal rule, speci…ed as an error correction model, in which the primary surplus responds to debt and a target variable. We show that for the monetary authority to have the freedom to control price, the primary surplus must respond strongly enough to lagged debt. Using panel techniques that allow for unit roots and for heterogeneity and cross-sectional dependence across countries, we estimate the coe¢ cients of the error correction model for the primary surplus in a panel of ten EMU countries over the period 1970-2006. The group mean estimate for the coe¢ cient on lagged debt is consistent with the hypothesis that the monetary authority can control the price level in the EMU, independent of …scal in ‡uence.

Fiscal Limits in Advanced Economies*

“…6 6 Work taking this approach includes Cochrane (2011), Daniel and Shiamptanis (2010), Davig et al. (2010, 2011), Davig and Leeper (2010) and Sims (2011). …”

Public Debt Sustainability and Defaults.

“…At this stage, we establish the equilibrium conditions of this economy taking as given the possible stochastic sequences of default threshold in each period: {Ω max t } . 16 A competitive equilibrium contingent to a sequence of default thresholds is defined as follows: It is a sequence of prices {W t , q t , {Q t,t+1 }} ∞ t=0 , policy instruments {τ t , h t }, and quantities {N t , Y t , C t , B t , {D t+1 }} ∞ t=0 such that, for all possible sequences of exogenous realizations {A t } ∞ t=0 and default thresholds {Ω max t } +∞ t=0 , households and firms solve their respective optimization problems, the accumulation equation of public debt holds, the taxation and default rules hold, and all markets clear. The market clearing conditions for respectively the good market, the labor market and the contingent asset market are, 15 Haircuts in sovereign debt restructuring for emerging market economies over 1998 and 2005 varied from 5% in Dominican republic to 72% in Argentina (see Sturzenegger and Zettelmeyer, 2008).…”

Fiscal Limits in Advanced Economies

“…Work taking this approach includes Cochrane (2011),Daniel and Shiamptanis (2010),Walker (2010, 2011),, and Sims (2011).4 The points that this illustrative model make have been generalized in numerical work byWalker (2010, 2011) and].…”