Fiscal Policy in Economic and Monetary Union

Fiscal Policy in Economic and Monetary Union

Theory, Evidence and Institutions

Marco Buti and Daniele Franco

This book explores the origins, rationale, problems and prospects of the European fiscal policy framework. It provides the reader with a roadmap to EMU’s budgetary framework by exploring its theoretical and empirical foundations, uncovering its historical roots and emphasising its supranational nature.

Chapter 4: Cyclical Stabilization

Marco Buti and Daniele Franco

Subjects: economics and finance, money and banking, public finance


* INTRODUCTION The policy assignment and institutional arrangements of EMU are based on a widespread consensus that monetary policy should take care of stabilization in the event of symmetric shocks while the smoothing of asymmetric shocks and diverging cyclical conditions falls to national fiscal policy as the single monetary policy responds only to area-wide price developments. The feasibility of this policy assignment rests of course on the assumption that fiscal policy is an effective stabilization tool. Recent academic literature assessing the functioning of the rule-based fiscal framework of EMU draws largely on the presumption that fiscal policy is indeed a useful stabilization instrument.62 This implies a turnaround in the views concerning the potency of fiscal policy interventions in smoothing cyclical fluctuations. Since the collapse of the Keynesian consensus in the second half of the 1970s, fiscal stabilization has become increasingly unpopular among academics and policy makers. While the real effects of fiscal policy were called into question in Barro’s (1974) seminal paper on Ricardian equivalence, Sargent and Wallace (1981) revealed ‘fiscal roots’ of high inflation in the form of debt monetization in the event of persistent budgetary imbalances.63 Reflecting these underpinnings, the task of short-term stabilization was left to monetary policy, whereas fiscal policy should be geared to medium-term structural issues and long-term sustainability of public finances. While the potential usefulness of fiscal stabilization is being reconsidered, the ‘heritage’ of the debate in the 1980s casts a strong scepticism over the use of discretionary fiscal action to...

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