Optimal Monetary and Fiscal Policy in a Currency Union

We lay out a tractable model for fiscal and monetary policy analysis in
a currency union, and analyze its implications for the optimal design of such
policies. Monetary policy is conducted by a common central bank, which sets
the interest rate for the union as a whole. Fiscal policy is implemented at
the country level, through the choice of government spending level. The model
incorporates country-specific shocks and nominal rigidities. Under our assumptions,
the optimal monetary policy requires that inflation be stabilized at the
union level. On the other hand, the relinquishment of an independent monetary
policy, coupled with nominal price rigidities, generates a stabilization role
for fiscal policy, one beyond the efficient provision of public goods. Interestingly,
the stabilizing role for fiscal policy is shown to be desirable not only from
the viewpoint of each individual country, but also from that of the union as
a whole. In addition, our paper offers some insights on two aspects of policy
design in currency unions: the conditions for equilibrium determinacy and
the effects of exogenous government spending variations.