Theory, Evidence and Institutions
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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