The unbearable tightness of being in a monetary union: Fiscal restrictions and regional stability

Evi Pappa, Vanghelis Vassilatos

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16 Citations (Scopus)

Abstract

We study how constrained fiscal policy can affect macroeconomic stability and welfare in a two-region model of a monetary union with sticky prices and distortionary taxation. Both government spending and taxes can be used to stabilize regional variables; however, the best welfare outcome is obtained under some tax variability and constant regional inflations. We use a variety of rules to characterize constrained fiscal policy and find that strict fiscal rules coupled with a monetary policy that targets union-wide inflation result in regional inflation stability and the welfare costs of such rules are not as unbearable as one would expect. Fiscal authorities can enhance welfare by targeting the regional output gap, while targeting regional inflation is less successful since inflation stability is guaranteed by the central bank. © 2007 Elsevier B.V. All rights reserved.
Original languageEnglish
Pages (from-to)1492-1513
JournalEuropean Economic Review
Volume51
DOIs
Publication statusPublished - 1 Aug 2007

Keywords

  • Budgetary restrictions
  • Fiscal rules
  • Monetary union
  • Optimal policy

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