Central bank reaction to public deficit and sound public finance: the case of the European Monetary Union

Canale, Rosaria Rita (2010): Central bank reaction to public deficit and sound public finance: the case of the European Monetary Union. Published in: Journal of Advanced Studies in Finance , Vol. Volume, No. Issue 1, Summer 2010 (August 2010): pp. 4-17.

Abstract

The paper aims to shed light on the relation between monetary and fiscal policy in EMU, focusing on the interest rates and deficit dynamics. We present a theoretical model in which monetary and fiscal policy independently interact in a closed economic system through their own instrument, namely, the rate of interest for the central bank and deficit spending for governments. We demonstrate that the possibility of the two policy authorities producing not conflicting results depends on the idea each has of the workings of the economic system and on the influence each variable has on inflation and equilibrium income. Furthermore the inflationary opinion of the ECB about deficit spending leads to the result that public finance becomes surely unsound, unless governments stop using expansionary instruments. We provocatively conclude that the limits set by the Maastricht Treaty are a necessary solution to avoid unsound public finance.

• Item Type: MPRA Paper
• Language: English
• Keywords: Monetary policy, Fiscal Policy, Policy coordination, EMU
• Subjects: E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E63 - Comparative or Joint Analysis of Fiscal and Monetary Policy ; Stabilization ; Treasury Policy; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E61 - Policy Objectives ; Policy Designs and Consistency ; Policy Coordination

References

Allsopp C. and Vines D. (2005), “The macroeconomic role of fiscal policy” in Oxford Review of Economic Policy, vol 21, no.4.

Arestis P. and Sawyer M. (1998), “Keynesian Economic Policies for the New Millennium”, in Economic Journal vol.108, no.446.

Arestis P. McCauley K. and Sawyer M (2001). “Commentary. An alternative stability pact for the European Union”, in Cambridge Journal of Economics, Jan, 13, pp.113-130.

Barro R. (1974), “Are government bonds net wealth?” in Journal of Political Economy, 82.

Bayoumi, T. and Masson P.R. (1995) “Fiscal Flows in the United States and Canada: Lessons for Monetary Union in Europe”, European Economic Review 39(2):253-74.

Becker, T. (1997) “An Investigation of Ricardian Equivalence in a Common Trends Model”, Journal of Monetary Economics 39(3): 405-31.

Bernheim, B. D. (1987) “Ricardian Equivalence: An Evaluation of Theory and Evidence”, in: S. Fischer, ed. NBER Macroeconomics Annual 1987: 263-304.

Bibow J. (2004), “Reflections on current fashion of central bank independence”, Cambridge Journal of Economics, n.28.

Blanchard, O. and Perotti, R. (2002), “An empirical characterization of the dynamic effects of changes in government spending and taxes on output”, Quarterly Journal of Economics, 117(2), 1329-1368.

Blanchard, O.J. (1985), “Debt, deficits and finite horizons”, Journal of Political Economy, 93(2), 223-247.

Blinder A. S. (1982), Issues on coordination of monetary and fiscal policy, NBER working paper no.982

Briotti, M.G. (2005), “Economic reactions to public finance consolidation: a survey of the literature”, Occasional Paper Series No. 38, Frankfurt: European Central Bank.

Buchanan, J.M. and Tullock G. (1962) The Calculus of Consent: Logical Foundation of Constitutional Democracy, University of Michigan Press, Ann Arbor, Mich.

Chadha, J.S., Nolan C. (2007), Optimal simple rules for the conduct of monetary and fiscal policy Journal of Macroeconomics, Volume 29, Issue 4, 1 December, pp. 665-689

Clarida R. Gali J. Gertler M.(1999), “The Science of Monetary Policy: a New Keynesian Perspective”, in Journal of Economic Literature, vol.37, no.4 Dec.

Douven R.C. Plasmans J.E.J (1997) Convergence and coordination in the EU: a dynamic games approach Control Engineering Practice, Volume 5, Number 4, April , pp. 561-566

Drazen, A. (2000) Political Economy in Macroeconomics, Princeton University Press, Princeton, N.J.

Eggerston, G. B. (2006), “Fiscal multipliers and policy coordination”, Federal Reserve Bank of New York Staff Reports, No. 241, New York: Federal Reserve Bank of New York.

Eichengreen, B. and Bayoumi T. (1994) “The Political Economy of Fiscal Restrictions: Implications for Europe from the United States”, European Economic Review 38(3-4): 783-91.

Eichengreen, B. Wyplosz C. (1993) “The Stability Pact: More than a Minor Nuisance?”, Economic Policy 26: 65-104. 32

Eisner, R. (1989), “Budget deficits: rhetoric and reality”, Journal of Economic Perspectives, 3(2), 73-93.

Euromemorandum Group (2006), “A Democratic Economic Policy Alternative to the Neo-liberal Transformation of Europe”, Euromemorandum 2006, December.

European Central Bank, (2004), Monthly Bulletin, April.

Fitoussi J.P. and Saraceno F. (2004), “The Brussels-Frankfurt-Washington Consensus. Old and New Tradeoffs in Economics, Observatoire Francaise de Conjunctures Economique, no.2004-2.

Fontana, G. and Palacio-Vera, A. (2005), “Are Long-run Price Stability and Short-run Output Stabilization all that Monetary Policy can Aim for?”, Levy Institute Working paper No. 430, November.

Forstater M. Mosler W. (2005), The natural rate of interest is zero, in “Journal of Economic Issues”, no.2, pp.536-542.

Galì J. Monacelli T. (2005), Optimal Monetary and Fiscal Policy in a Currency Union, IGIER Working paper.

Galí, J., López-Salido, J.D. and Vallés, J. (2004), “Understanding the effects of government spending on consumption”, ECB Working Paper Series No. 339, Frankfurt: European Central Bank.

Giavazzi F. Pagano M., (1996), “Non Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish experience”, Swedish Economic Policy Review, May

Godley W. and Lavoie M. (2006), “A Simple model of three economies with two currencies: the eurozone and the USA, Cambridge Journal of Economics, n.23

Gruen, D. W. R. (1991) “What People Know and What Economists Think They Know: Surveys on Ricardian Equivalence”, Australian Economic Papers 30(56): 1-9.

Hemming, R., Kell, M. and Mahfouz, S. (2002), “The effectiveness of fiscal policy in stimulating economic activity: a review of the literature”, IMF Working Paper 02/208, Washington D.C.: International Monetary Fund.

Hemming, R., Mahfouz, S. and Schimmelpfennig, A. (2002), “Fiscal policy and economic activity in advanced economies”, IMF Working Paper 02/87, Washington D.C.: International

Kaldor N. (1982), The Scourge of Monetarism, Oxford University Press, Oxford.

Kirsanova T., Stehm S. J. and Vines D (2005), “The interaction between fiscal policy and monetary policy”, in Oxford Review of Economic Policy, vol 21, no.4.

Krugmann P. (2005), “Is fiscal policy poised of a comeback?” in Oxford Review of Economic Policy, vol 21, no.4.

Kydland, E.F. and Prescott, E.C. (1977), “Rules rather than discretion: the inconsistency of optimal plans”, Journal of Political Economy, 85(4), 473-491.

Lambertini L. Rovelli R. (2004) Monetary and fiscal policy coordination and macroeconomic stabilization. A theoretical analysis, Discussion paper, Dipartimento di Scienze Economiche, Università di Bologna.

Melitz J. (2000) “Some Cross-Country Evidence About Fiscal Policy Behaviour and Consequences for EMU”, European Economy 2: 3-21.

Nordhaus W. D. (1994), Policy Games: Coordination and Independence in Monetary and Fiscal policies, in Brookings Papers on Economic Activity, Vol. 1994, No. 2. pp. 139-216.

Palacio-Vera A. (2005), “The ‘modern’ view of macroeconomics: some critical reflections”, Cambridge Journal of Economics, n.29

Perotti, R. (2005), “Estimating the effects of fiscal policy in OECD countries”, CEPR Discussion Paper 4842, London: Centre for Economic and Public Policy.

Romer D. (2000), “Keynesian macroeconomics without the LM curve”, in Journal of Economic Perspectives, vol.14, n. 2

Sargent T. Wallace N. (1975), “ ‘Rational expectations’ the optimal monetary instrument and the optimal money supply rule” in Journal of political economy, 83.

Sawyer, M.C. (2002), “The NAIRU, Aggregate Demand and Investment”, Metroeconomica, 53(1), 66-94.

Seater, J. J. (1993) “Ricardian Equivalence”, Journal of Economic Literature 31(1): 142-190

Setterfield, M. (ed.) (2002), The Economics of Demand-led Growth: Challenging the Supply-side Vision of the Long Run, Cheltenham (UK): Edward Elgar.

Smets, F. and Wouters, R. (2003), “An estimated Stochastic Dynamic General Equilibrium model of the euro area”, Journal of the European Economic Association, 1(4), 1123-1175.

Solow R. (2005), “Rethinking fiscal policy”, in Oxford Review of Economic Policy, vol 21, no.4.

Symposium (2002), “The Making of Monetary Policy in Endogenous Money Theory”, Journal of Post Keynesian Economics, 24(4), 503-607

Taylor, J. (2000) “Reassessing Discretionary Fiscal Policy”, Journal of Economic Perspectives 14(3): 21-36.

Taylor, J.B. (2000), “Discretionary fiscal policies”, Journal of Economic Perspectives, 14(1), 1-23.

Tinbergen J. (1952), On the Theory of Economic Policy, North Holland, Amsterdam.

Tobin J. (2001), Fiscal Policy: Its Macroeconomics in Perspective, Cowles Foundation Discussion paper, no.1301.

Van Aarle, B. and Garretsen, H. (2003), “Keynesian, non-Keynesian or no effects of fiscal policy changes? The EMU case”, Journal of Macroeconomics, 25(2), 213-240. Walsh, Carl E. (1995) “Optimal Contracts for Central Bankers”, American Economic Review 85(1): 150-67. Weber, A. (2006), “Interest rates in theory and practice – how useful is the concept of the natural real rate of interest for monetary policy?”, Inaugural G.L.S. Shackle Biennial Memorial Lecture, University of Cambridge, 9 March. Wray L. R. (2007), Fixed and Flexible Exchange Rates and Currency Sovereignity, Levy economic Institute of Bard College, Working Paper No.489.

Wren-Lewis, S. (2000), “The Limits to Discretionary Fiscal Stabilisation Policy”, Oxford Review of Economic Policy, 16, 92-105.

Wyplosz C. (2001) ed. The Impact of EMU on Europe and the Developing Countries, Oxford University Press, Oxford.

Wyplosz, C. (2005) “Fiscal Policy: Institutions versus Rules”, in National Institute Economic Review, no.191, January.