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 5: Interactions between Monetary and Fiscal Policies

Marco Buti and Daniele Franco

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

Extract

5. Interactions between monetary and fiscal policies* 1. INTRODUCTION The completion of Economic and Monetary Union (EMU) – based on the mandate given to the European Central Bank (ECB) to maintain price stability and guidelines for the conduct of national fiscal policies – has prompted renewed interest in the interplay between monetary and fiscal policies (Buti, 2003a). The traditional Optimal Currency Areas literature pointed out long ago that, in a monetary union, fiscal policy has to play a more important role in cyclical stabilization given the loss of national monetary independence. This is particularly the case if shocks are not perfectly correlated across frontiers. Fiscal flexibility, together with budgetary discipline and coordination, has come to be seen as a central pillar of fiscal policy in a currency area (European Commission, 1990). The Stability and Growth Pact (SGP) has been the operational response of EU countries to the quest for budgetary discipline in EMU. Recent theoretical and empirical developments have shed new light on the ‘old’ issue of the interactions between monetary and fiscal authorities. The theoretical literature reviewed here looks at the rationale for budgetary constraints but rarely embodies explicitly EMU and SGPrelevant rules in budgetary behaviour. While a number of studies, like for example those of Aarle et al. (2000), Bennett and Loayza (2000) and Leitmo (2000), encompass a cost of ‘fiscal policy activism’, to our knowledge, no paper encompasses the 3 per cent plus ‘close-to-balance’ rule of the SGP, which would ensure budgetary prudence while leaving room for manoeuvre for...

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