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 two-country monetary union, incorporating adaptive expectations. An asymmetry between the stabilisation properties of the two fiscal policies is introduced: only one country is fiscally-constrained by the dispositions of the stability pact. Monetary and fiscal policies are set as the outcomes of a game between the two governments and the common central bank. We show that in case of negative symmetric shocks with a stringent monetary policy, the government with sound public finances is more and more fettered in his policy choices as time moves forward while the reserve is true for the fiscally-constrained government. The costs implied by the stability pact for the common central bank are also substantial. Coordinating monetary and fiscal policies after a symmetric supply shock is also shown to be sufficient to cancel the costs emerging from the pact, but it is not after a demand shock.