Fiscal Policy in the European Monetary Union

42 Pages Posted: 27 Jan 2009

See all articles by Betty C. Daniel

Betty C. Daniel

Board of Governors of the Federal Reserve System

Christos Shiamptanis

Trent University - Department of Economics

Date Written: December 26, 2008

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 fiscal limits in the Maastricht Treaty and the Stability and Growth Pact is implicitly a promise not to allow its fiscal stance to deteriorate to a position in which it places pressure on the central bank to forgo its price level target to finance fiscal deficits. Violation of these limits has raised questions about potential fiscal encroachment on the monetary authority's freedom to determine the price level. We specify a simple model of fiscal policy in which the fiscal authority faces an upper bound on the size of its primary surplus. Policy is determined by a fiscal rule, specified 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 coefficients 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 coefficient on lagged debt is consistent with the hypothesis that the monetary authority can control the price level in the EMU, independent of fiscal influence.

Keywords: European Monetary Union, monetary policy, fiscal policy, Fiscal Theory of the Price Level, panel cointegration, error correction

JEL Classification: C32, C33, E42, E62, F33

Suggested Citation

Daniel, Betty C. and Shiamptanis, Christos, Fiscal Policy in the European Monetary Union (December 26, 2008). FRB International Finance Discussion Paper No. 961, Available at SSRN: https://ssrn.com/abstract=1333322 or http://dx.doi.org/10.2139/ssrn.1333322

Betty C. Daniel (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Christos Shiamptanis

Trent University - Department of Economics ( email )

1600 West Bank Drive
Peterborough, Ontario K9J 7B8
Canada

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