On the Logic of Fiscal Policy Coordination in a Monetary Union

Fiscal policies have been widely criticized for their failure to act as a stabilizing countercyclical force in the European Monetary Union (EMU) prior to the Financial Crisis of 2008, and even more so thereafter. Motivated by EMU experience, this paper lays out a parsimonious model of fiscal-monetary policy interaction between national fiscal authorities and a common central bank. It is well known that the structure of this interaction changes fundamentally when the central bank is constrained by a binding zero lower bound on the interest rate. This paper demonstrates that decentralized fiscal policies suffer from a systematic procyclical bias in a monetary union, both when the zero lower bound bites and when it does not. Whereas the existing literature on fiscal policy coordination knows "locomotive games" and "discipline games", in which fiscal policies are too tight or too loose, respectively, the analysis in this paper identifies a more general "stabilization game" in which coordination can play a useful role by strengthening the countercyclical thrust of fiscal policies.