Spillover Effects of Fiscal Policy in EMU: A Misconception behind the Stability Pact?

Abstract

This paper extends the Mundell-Fleming model to a monetary union between two countries that are different with regard to the determinants of aggregate demand, demand for money, foreign trade, price and wage adjustment. Depending on these national disparities in structural parameters, a fiscal expansion in one country is not necessary more effective in a monetary union than in a fixed exchange rate area, and its spillover effects are not bound to be negative. Thus, the results cast doubt on an underlying argument behind the Stability and Growth Pact in EMU.

Keywords: fiscal policy, monetary union, Mundell-Fleming, Stability Pact, wage indexation

JEL Classification: E60, E63, F33, F41