Macroeconomic Stabilization through Monetary and Fiscal Policy Coordination: Implications for European Monetary Union

Board of Governors of the Federal Reserve System International Finance Discussion Papers Number 453 September 1993

MACROECONOMIC STABILIZATION THROUGH MONETARY AND FISCAL POLICY COORDINATION: IMPLICATIONS FOR EUROPEAN MONETARY UNION

Jay H. Bryson

NOTE: International Finance Discussion Papers are preliminary materials circulated to stimulate discussion and critical comment. References in publications to International Finance Discussion Papers (other than an acknowledgment that the writer has had access to unpublished material) should be cleared with the author or authors.

ABSTRACT

In a two-country model, we consider the implications of monetary and fiscal policy coordination for macroeconomic stabilization. We show that the optimal regime is one of monetary and fiscal policy coordination under flexible exchange rates. In the context of the European Community, this suggests that the desire to fix exchange rates may not be costless. In addition, we show that, under an asymmetric demand shock, fiscal coordination requires a relatively high degree of flexibility in fiscal policy. This suggests that limits on the flexibility of fiscal policies, as suggested in the Delors Report, may hinder macroeconomic

stabilization.

Macroeconomic Stabilization Through Monetary and Fiscal Policy Coordination: Implications for European Monetary Union

Jay H. Bryson’

1. Introduction

Upon entering Stage Three on the road to monetary union, the member states of the European Community will enter an economic policy regime in which monetary policy, by necessity, will be coordinated, but fiscal policy may or may not be coordinated.’ Because itis very likely that these economies will continue to experience stochastic disturbances, it would be useful to know the implications of simultaneous monetary and fiscal policy coordination for macroeconomic stabilization. Although the literature on macroeconomic policy coordination has become quite voluminous, it does not, to our knowledge, address these implications. The objective of this paper is to begin to fill this void and to use the results to address the implications of monetary and fiscal policy coordination for macroeconomic stabilization in the proposed European Monetary Union (EMU).

The early literature on policy coordination addressed either monetary coordination, ignoring fiscal considerations, or fiscal coordination, ignoring monetary considerations.

The contributions of Canzoneri and Gray (1985) and Canzoneri and Henderson (1988, 1991) provide very useful insights into macroeconomic stabilization through monetary policy coordination, however, these contributions ignore fiscal policy considerations. Although eschewing monetary policy considerations, Kehoe (1987) and Turnovsky (1988) analyze the gains

from fiscal coordination through very elegant deterministic neo-classical models. De Grauwe

" The author is a staff economist in the Division of International Finance. This paper represents the views of

the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal

Reserve System or other members of its staff. 1 would like to thank, without implicating, Dale Henderson, David VanHoosc. Henrik Jensen and participants in the Division of International Finance Workshop at the Federal Reserve for helpful comments and suggestions.

~ In Stage Three, exchange rates will become irrevocably fixed and a common currency may eventually replace individual country currencies. For a description of the different stages on the road to EMU sec Commission of the European Communitics (1989).

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(1990) considers the stabilizing properties of fiscal policy coordination in a stochastic environment, but ignores the implications of monetary policy.

Some recent papers incorporate monetary and fiscal policies in the same model. Van der Ploeg (1992) considers the stabilizing properties of fiscal policy within various exchange rate regimes; however, monetary policy is exogenously specified and is not used as a stabilization tool. Sheen (1992) analyzes the stabilizing nature of monetary and fiscal policy coordination under various assumptions about supply behavior but does not consider both policies simultaneously. Bryson, Jensen, and VanHoose (1993) consider the implications of simultaneous monetary and fiscal policy coordination, but do so in a non-stochastic framework.

To address the implications of monetary and fiscal policy coordination for macroeconomic stabilization, we consider two interdependent economies that experience stochastic disturbances. Monetary and fiscal authorities in a domestic and foreign country choose their respective policies to minimize specified social loss functions. We consider two separate policy regimes under two separate exchange rate regimes. In the first policy regime, monetary policies are coordinated through the minimization of a joint social loss. function. However, fiscal policies are chosen non-cooperatively. In the second policy regime, monetary and fiscal policies both are coordinated. We consider both of these policy regimes under a flexible exchange rate and under a fixed exchange rate. We then analyze the stabilizing properties of these four permutations not only in the face of a common productivity shock, the focus of much of the coordination literature, but also in the face of a demand shock that switches expenditure from the foreign country to the domestic country.’ Thus, we consider eight separate cases."

The results suggest three issues that are relevant for EMU. First, the social loss

associated with a regime of monetary and fiscal policy coordination is always less than that

* Notable exceptions to the focus on common productivity shocks include von Hagen and Fratianni (1991) and Currie, Levine, and Pearlman (1992). Both papers consider asymmetric shocks.

To keep the paper to a reasonable Iength and to focus on cases most relevant for EMU, we do not report results for a regime of insular monctary and fiscal policymaking. Our gencral conclusions arc not altered by this omission.

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associated with a regime in which only monetary policy is coordinated. This result suggests that the need for fiscal policy coordination that is emphasized in the Maastricht Accord is well-founded. Second, if monetary and fiscal policies are coordinated, the social loss associated with a fixed exchange rate is never less than that associated with a flexible exchange rate. This result suggests that the desire to fix exchange rates among EC member states may not be costless. Third, the stabilization of an asymmetric demand shock when monetary and fiscal policies are coordinated may require a relatively high degree of fiscal policy flexibility. This result suggests that limits on the flexibility of fiscal policies,

as suggested in the Delors Report, may hinder macroeconomic stabilization.

The paper is organized as follows: Section 2 presents a two-country model under flexible exchange rates and compares the stabilizing properties of the policy regimes in the face of two separate disturbances. Section 3 does the same for a fixed exchange rate. Section 4 compares outcomes between the flexible and fixed exchange rate regimes. Section 5

offers conclusions and some implications for stabilization policy under EMU. 2. Flexible Exchange Rate Regime

2.1 Tre Model We consider an extension of the two-country model of Canzoneri and Henderson (1988). Each country is specialized in the production of one good, but consumers in both countries consume both goods. All variables are expressed in logarithmic form and time subscripts are suppressed where possible for notational convenience. The supply curves, which are derived in the appendix, are given by y = ap + (1+a)x (1) y =ap + (14a)y a") where y (y) is output of the domestic (foreign) good, p (p ) is the price of the domestic

(foreign) good, and x is a white noise productivity shock common to both countries.

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We assume that the only asset held by residents of each country is the money of that country’. The money market equilibrium conditions can be written y+p=m (2) * * * * y +p =m (2 ) where m (m ) is the domestic (foreign) money supply. The equilibrium conditions for domestic

and foreign goods are given by

y=8(p +e-p)+(I-B)y + By +g 4 (3) y = 8(p-p =e) + (I-B)y"+ By+ gv (3°) where e is the nominal exchange rate expressed in units of domestic currency per unit of foreign currency, g (g ) is domestic (foreign) government spending on the domestic (foreign) good, v is a white noise demand shock that switches expenditure from the foreign good to the domestic good, hereafter referred to as an asymmetric demand shock, and B is the marginal propensity to import where 0 < B < 0.5.° By setting p, ; =P, _; =¢,., =. CPI inflation is given by Y= (1-B)p + B(p +e) (4) y= (1-B)p + Bip - e) (4°)

Employment, derived in the appendix, is given by

n= a,(p+y) (5) n= o(p + x) (5) Solving equations (1) - (3) yields the following semi-reduced-form expressions: * 2 y = Qom + x y =Qqm + x * *

P = (1-aq)m - x f°) = (-a)m -x

- * * e= 2G) + %B mem) - 1 ge g*)- hy (6)

5 26 5

* In an carlicr version of the paper, we assumed that residents hold the moncy of their country plus a bond

that is perfectly substitutable for the bond in the other country. Under this assumption, the following moncy markct and goods market cquilibrium conditions are functions of the world intcrest rate. Because the qualitative nature of the following results do not change, we cschew interest rate considerations.

’ Because bonds do not appear in the modcl, g could be thought of as a balanced budget change in government spending.

2 2 p = 5(1-a9) + OB m - %o8 m -8 (gy) -8y ) fs) 26 3) * 8? d(l-a,) +a B2 * £6 * B Y =-_0" m+ 0 Ow m +f i(g-g)-x+Fv ) ) 26 ) Ed * n=m n =m

A domestic monetary expansion, which creates an excess supply of domestic money, raises the price of the domestic good and thereby increases domestic employment and output. The resulting excess supply of goods induces a nominal exchange rate depreciation to equilibrate the domestic goods market. The increase in the price of the domestic good and the exchange rate depreciation raise the domestic CPI. In this model, the effect of fiscal policy is confined to the goods market. A domestic fiscal expansion, which creates an excess demand for domestic goods, induces nominal exchange rate appreciation and thereby produces domestic (foreign) disinflation (inflation).’

A negative (positive) productivity shock, which by assumption affects both countries symmetrically, lowers (raises) output levels and raises (lowers) prices, but has no effect on the exchange rate. A negative (positive) productivity shock has no effect on employment because the resulting decrease (increase) in labor demand is offset by higher (lower) prices.

An asymmetric demand shock, which appreciates the exchange rate, produces domestic (foreign) disinflation (inflation).

The domestic social loss function is

= (1/2) 19 + yn? + Wye? (7)

and the foreign counterpart is O° = (2) (0)? + y(n) + Ba(e")7] (7)

That is, we assume that deviations of CPI inflation, employment, and government spending from

Fiscal policy would affect prices and the levels of employment and output if interest rates were added to moncy demand.

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. . 8 target levels, here normalized to zero, reduce social welfare.

2.2 Productivity Shock

As discussed above, a negative productivity shock raises domestic and foreign CPI inflation but leaves domestic and foreign employment unaffected. In what follows, we consider two different policy regimes to respond to the disturbance: a regime of monetary coordination in which the monetary authorities optimize a joint social loss function but the fiscal authorities act in an insular fashion, and a "combined" coordination regime of monetary and fiscal policy coordination.’ Under monetary coordination, the domestic monetary authority chooses the domestic money supply so that aob/am + ab /am = 0 (8) while the foreign monetary authority chooses the foreign money supply so that ab /am’ + do/am'= 0 (8) The domestic [foreign] fiscal authority chooses domestic [foreign] government spending to minimize (7) (7 )h. The equilibrium policy choices and resulting reduced-form expressions for inflation and employment are (where MC implies monetary coordination) mMC - nMic ~m MCL nMC_C 1-1) x (ag)? +H

MC__*MC - Bu,

g ~=g = x (9)

28pyl(1-o9) ? + 41

* The inclusion of CPI inflation and employment in the social loss function is standard in the stabilization literature. The inclusion of the third argument implics that there is some optimal Icvel of government spending, here normalized to zcro. Below this level, there is a social loss associated with say, insufficient spending on infrastructure, while above this level, excessive government spending could result in long-tcrm solvency problems. This term also can serve as a proxy for the preoccupation with fiscal imbalances in the Delors Report and the subsequent Maastricht Accord. Cohen and Wyplosz (1989) and van der Plocg (1992) also include government spending in the social loss function.

Following Canzoncri and Henderson (1988), we assume that policymakers can credibly commit to coordinate macrocconomic policies.

MC _ y*MC _ By (-ay) 7 +4, A negative productivity shock, which raises domestic and foreign CPI inflation, induces expansionary fiscal policies and contractionary monetary policies.' ° Although the money supply reductions contribute to less rapid inflation, they lower employment levels. Under a regime of combined coordination, the monetary and fiscal authorities both optimize the joint social loss function.'' Hence, monetary authorities continue to choose their respective money supplies to satisfy (8) and (8). The domestic fiscal authority chooses domestic government spending so that d0/dg+ a /dg =0 (10) and the foreign fiscal authority chooses foreign government spending so that ab /dg + do/ag =0 (10°) The equilibrium policy choices and resulting reduced-form expressions for inflation and

employment are (where CC implies "combined coordination")

meC& _ nce - m Cf _ n Cc - ( 1-a9) _y (1a)? + Hy gC = g Ce 0 (11) wCC _ yp CC - - Hy 1 2 (1-09) "+ Hy Comparing (11) to (9) reveals that me = mMC no = nMc po = yMiC and goo < gMc

The domestic fiscal authority, which acts in an insular fashion in the MC regime, perceives an ex ante opportunity to export inflation to the foreign country through exchange rate appreciation that results from fiscal expansion. Likewise, the foreign fiscal authority

perceives the same ex ante opportunity; however, ex post, the exchange rate remains unchanged

™ Ttcan be shown that monctary policies are less contractionary under monetary coordination than under a regime in which the monctary authoritics act in an insular fashion. This result supports Canzoncri and Henderson (1988).

'* Because the domestic (foreign) monctary authorities have the same welfare function as the domestic (foreign) fiscal authorities, this regime is similar to a regime in which monetary and fiscal policies are coordinatcd

not only across countries but also within countrics.

due to the symmetry of the model. When fiscal policy is coordinated, this externality 1s internalized, thereby reducing the ex ante incentive for fiscal expansion. Indeed, the optimal fiscal policy response under fiscal policy coordination is zero due to the inability of fiscal policy to affect prices and employment levels.'? Because CPI inflation and employment are equal in the two regimes but government spending is lower under CC, the social

loss is unambiguously lower under CC than under MC.! * 2.3 Asymmetric Demand Shock’ *:

An asymmetric demand shock causes exchange rate appreciation thereby producing domestic (foreign) disinflation (inflation). Employment levels initially are unchanged. When monetary authorities coordinate but fiscal authorities act in an insular fashion, the

equilibrium policy choices and reduced-form expressions are

2 MC _ pMC _ np *MC __,*MC _ 2Buof (1-09) +2098] sy

2,2 2 z 2p5/8(C1- ay) +2a08 +H 1B +26 Ho]

2 gM eg (MC2 Bl (12) 2pg13(|I-a9)+20 98717 + 11874267 Ho| yMC _ ap MC _ -2Pdp 5p, y

2,2 2 452 25] 5(1-a5)+209 B | + HIB +26 LI

The optimal domestic (foreign) monetary response is expansionary (contractionary). An increase in the domestic money supply causes exchange rate depreciation, thereby offsetting

the domestic (foreign) disinflation (inflation). Analogous reasoning holds for the

This result was also found in an carlicr version of the paper in which fiscal policy affected priccs.

The movement from a situation in which only a subset of players coordinatc to a situation in which all playcrs coordinate can explain this welfare improvement also.

A symmetric demand shock could be completcly offsct with monctary policy in both regimes: conscquently, there would be no gain (or loss) from fiscal coordination.

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contractionary foreign response.

To induce exchange rate depreciation also, the domestic (foreign) fiscal authority lowers (raises) government spending. Under a regime of combined coordination, the equilibrium policy choices and reduced-

form expressions are

2 2,2 2, <2 cC_ *CC -p° g = -g "= aa v (13) 2 2 byl 5(1-019)+2c4)87] + n[B>+8 Ho] wCoC _ ap*CC _ - Bopou, y 2 H9l5(1-c¢9)+209 87] 7 + 1 y1B7+57H5) It can be shown that ge < gMc (g CC > g MC) that is, domestic (foreign) fiscal policy is

more contractionary (expansionary) under CC than under MC. Under MC, the domestic (foreign) fiscal authority, which sets its policy taking other policies as given, perceives an ex ante opportunity to export disinflation (inflation) to the foreign (domestic) country through exchange rate depreciation. Constraining the domestic (foreign) fiscal authority’s desire to reduce (raise) domestic (foreign) government spending is the social cost of fiscal deviation. The ex post increase (decrease) in foreign (domestic) government spending produces more exchange rate depreciation, and therefore more exportation of disinflation (inflation), than the domestic (foreign) fiscal authority perceives ex ante. That is, from the standpoint of the domestic (foreign) authorities, the foreign (domestic) fiscal response pushes the exchange rate in the right direction.

Under CC, the fiscal authorities internalize this externality and recognize ex ante the welfare gain from further policy action. For the domestic (foreign) fiscal authority, the

marginal gain from further exportation of disinflation (inflation) outweighs the marginal

"Tucan be shown that monetary policics arc more responsive under monctary coordination than under a regime in which the monetary authoritics act in an insular fashion. This result holds because a coordinating monctary authonty internalizes the beneficial effect its policy has on the inflation rate of the other country. Note

the contrast with a common productivity shock where monetary coordination induces less monclary policy activism.

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cost of further fiscal deviation. Therefore, the domestic (foreign) fiscal authority

contracts (expands) more under CC than under MC. Consequently, we C <¥ re (i.e. more

MC Cc

* . . >? Cc (i.e. more foreign inflation occurs

* domestic disinflation occurs under MC) and ¥ t

under MC).

* In addition, it can be shown that m&© < mMC (m cc

*CC

> m MC), and hence, no© < nMc

(n > n MC) That is, domestic (foreign) monetary policy is less expansionary (contractionary) under CC than under MC due to the greater fiscal response under CC.

Substitution of the above expressions into the welfare functions shows that the social loss

is unambiguously higher under MC than under CC. 3.‘ Fixed Exchange Rate Regime

3.1 The Model Under a fixed exchange rate regime, the supply curves continue to be given by (1). The equilibrium conditions for the domestic and foreign goods become * * y= 8(p -p)+(-By+ By +gt+v (14) * * * * * y =d(p-p )+(1-B)y + By+g -v (14) The only difference between (14) and (3) is the exclusion of the exchange rate in the former. The money market equilibrium conditions are y+p=d+r (15) x * * y+pe=-r (15 ) where d is the domestic credit component of the monetary base and r is foreign exchange reserves. The expressions in (15) reflect the fact that only one central bank can have an independent monetary policy under a fixed exchange rate.

Solving equations (1), (14), and (15) yields the following semi-reduced-form

expressions:

1]

a a * a y=_O0d+_ 0—C (EB - +H XH +L CO 2 4 O08 + 8(1-a)] 2|oo6 + 5(1-a,)] y"=%d-___% —sg-g ) +x - o v 2 AlonB + 8(1-a9)] 2| a8 + 8(1-a9)] p= F%) q+ _ (1%) ge g*)- y+ _ (1% iv 2 Alan + 5(1-a9)] 2[ao8 + 5(1-a9)I o _ (1-a) g ; ( 1- X) (g - - 7 ( 1- a) Vv 2 4[anB + d(1-a)| 2[ao8 + d(1-a)] r=-lq + I (g-g) + : v (16) 2 4[anB + 5(1-a)I 2[ao6 + 5(1-o9)]

2 4l a8 + 5( 1- a)] 2[% 8 + 8( 1- a)]

yt = (ety) g C1 91-28) ig g*®) yy - Cag 1-28) oy 2 AjayB + 8(1-a,)l 2apB + 5(1-a,)] n=la+_ | gg) + _ 2 Hob + 8(1-ap)] 2ap8 + 6(1-a9)1 lg. e-e") y

_ ee £)- 2 4[anB + 5(1-a9)1 2[ao6 + 5(1-o9)]

An expansion of domestic credit creates an excess supply of domestic money that raises the domestic price, thereby increasing domestic employment and output. In addition, the excess supply of domestic money creates a domestic balance-of-payments deficit, and therefore a foreign balance-of-payments surplus that induces identical effects on foreign variables.

A comestic fiscal expansion creates an excess demand for the domestic good that raises its price, thereby increasing domestic employment and output. The domestic price increase creates a domestic excess demand for money that induces a balance-of-payments surplus that reduces the foreign price, which in turn reduces foreign employment and output. A foreign fiscal expansion has exactly converse effects. Therefore, fiscal expansion is a beggar-thy-

neighbor policy.

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The effects of a productivity shock under a fixed exchange rate are identical to those under a flexible exchange rate, but the effects of a demand shock differ between the two regimes. Whereas a demand shock under a flexible exchange rate causes domestic (forei gn) disinflation (inflation) but leaves real variables unaffected, a demand shock under a fixed exchange rate creates domestic (foreign) inflation (disinflation) and raises (lowers) the levels of domestic (foreign) employment and output.

In what follows, monetary coordination will imply a situation in which the domestic monetary authority optimizes the joint social loss function.' © That is, the domestic monetary authority chooses domestic credit so that

a0/ad + 9b /dd = 0 (17) The reserve flows between the domestic and foreign country that are induced by the change in domestic credit will insure that the change in the foreign money supply equals the change in

the domestic money supply, thereby keeping the exchange rate fixed.

3.2 Productivity Shock

A negative productivity shock raises domestic and foreign CPI inflation but leaves domestic and foreign unemployment unaffected. When the domestic monetary authority optimizes the joint social loss function but fiscal authorities act in an insular fashion, the equilibrium policy choices and reduced-form expressions are

qMC_ _2(1- 09)

(1-09)? +H,

x

eMC _ ,*MC _ - (-op) Bu, x (18) 2wylayB + 3(1-aq)][ (1-aiy)” + 44] yMC _ y*MC _ - Hy x

2 (1-a9) + Hy

"® Th the context of EMU, this could represent a common monetary policy that is determined by the ECB which is mindful of cach member’s welfare.

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aMC_*MC_ ( L-ap)

(1-9) + Hy To offset the inflationary impact of the shock, the domestic monetary authority reduces domestic credit thereby creating a domestic balance-of-payments surplus which in turn reduces the foreign money supply. The money supply reductions cause the employment levels to fall in each country. To offset lower employment, fiscal authorities raise government spending in their respective countries. Under monetary and fiscal policy coordination, the equilibrium policy choices and

reducecd-form expressions are qe — 2(1- ay)

5 x (1-a) + Hy ge _ g ce =() (19)

yCC _ yp CC _ Hy x

(1-a) 2 + Hy nce _ n Cf _ 1-9) x

2 (1-9) + Hy Comparing (18) to (19) reveals that ac& = gMc nc& = nMiC yo = pC and gC < gMC

In the MC regime, the domestic fiscal authority perceives an ex ante opportunity to offset lower employment resulting from monetary contraction. Likewise, the foreign fiscal authority perceives the same ex ante opportunity; however, due to the beggar-thy-neighbor effect of fiscal policy the ex post employment levels remain depressed. When fiscal policy is coordirated, this externality is internalized, thereby causing the ex ante fiscal response to equal zero. Because inflation and employment are equal in the two regimes but government

spending is lower under CC, welfare is unambiguously higher under CC than under MC.

3.3 Asymmetric Demand Shock

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By switching expenditure from the foreign good to the domestic good, an asymmetric demand shock creates domestic inflation and raises the level of domestic employment while causing converse changes in foreign variables. When the domestic monetary authority optimizes the joint social loss function but fiscal authorities act in an insular fashion,

the equilibrium policy choices and reduced-form expressions are

dMC 9) MC_ _*MC -[(1-0,) (1-28)? + po] 2 2 2 2 2 2 (1-a9) (1-2B)" + hy + 8 5[a96 + 5(1-a)] AMC __,*MC _ Ap5| OB + 8( 1-9) | y

(1-aiy)"(1-28)? + wy + 8uglapB + 8(1-ay)I”

Because the demand shock has identically opposite effects on domestic and foreign variables, the optimal response by the domestic monetary authority, who optimizes the joint social loss function, is to keep domestic credit unchanged. To offset higher (lower) employment, the domestic (foreign) fiscal authority reduces (increases) government spending.

Under monetary and fiscal policy coordination, the equilibrium policy choices and

reduced-form expressions are CC

d = () cc_ *cC -[C1-on) 2( 1-28)2 + ya] g -=-g = “oO 26 aa v 2 2 2 (1-a) (1-2B)~ + Hy + 4. OB + 5(1-a)] CC _ ap CC _ 2H5(1-a, |- 2B) lo B + 8( 1-a) v (21) 2 2 2 (1-op) (1-2B)~ + hy + 45loB + 5(1-a)| nc€ = CC _ 2p5I Oy B + 8( 1-a) | y

2 2 2 (1-a) (1-2B)~ + My + 4p 5lao8 + 5(1-a)]

* CC . MC g CC MC

(

is more contractionary (expansionary) under CC than under MC. Under MC, the domestic fiscal

* It can be shown that g >g ), that is, domestic (foreign) fiscal policy

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authority perceives an ex ante Opportunity to reduce inflation and employment through fiscal contraction. Likewise, the foreign fiscal authority perceives an ex ante opportunity to

reduce disinflation and unemployment through fiscal expansion. Constraining each fiscal authority is the social cost of fiscal deviation. The beggar-thy-neighbor effect of fiscal

policy causes more ex post reduction in domestic (foreign) inflation (disinflation) and employment (unemployment) than perceived ex ante. Analogous to combined coordination under flexible exchange rates, the foreign (domestic) fiscal response pushes the domestic (foreign)

price in the right direction from the standpoint of the domestic (foreign) authorities .

Under CC, the fiscal authorities internalize this extemality and recognize ex ante the welfare gain from further policy action. For the domestic (foreign) fiscal authority, the marginal gain from further inflation (disinflation) and employment (unemployment) reduction outweighs the marginal cost of further fiscal deviation. Therefore, domestic (foreign) fiscal policy is more contractionary (expansionary) under CC than under MC. Consequently, MC CC *MC < we MC > nce a *MC_ *CC

Y > aan and ¥, ndn <n . Substituting the

: . In addition n

expressions in (20) and (21) into the welfare functions shows that the social loss is

unambiguously higher under MC than under CC. 4. Exchange Rate Regime Comparisons

In the above analysis, we held the exchange rate regime constant and compared outcomes between policy regimes. To ascertain the implications of the exchange rate regime choice, we now hold the policy regime constant and compare outcomes between exchange rate regimes.

Consider the case of a common productivity shock. Comparison of (9) with (18) reveals that in the absence of fiscal policy coordination a flexible exchange rate will yield the same inflation rate and employment level but more fiscal expansion than a fixed exchange rate. Under a flexible exchange rate, each fiscal authority perceives an ex ante opportunity

to export inflation through exchange rate appreciation. Under a fixed exchange rate, the

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incentive for fiscal expansion is dampened due to its inflationary effect. Consequently, fiscal policy under a fixed exchange rate is less expansionary than under a flexible exchange rate. Because the only difference between the two exchange rate regimes is more fiscal expansion under a flexible exchange rate, the social loss is lower under a fixed exchange rate when fiscal policies are not coordinated.! ’

Under combined coordination, fiscal authorities internalize their respective policy externality. Regardless of the exchange rate regime, fiscal policy will be unresponsive to the common productivity shock as inspection of (11) and (19) confirms. In addition, the exchange rate regimes produce the same inflation and employment outcomes. Consequently, the exchange rate regimes are equivalent under combined coordination.! °

From the results of Sections 2 and 3 we can conclude that regardless of the exchange rate regime, a regime of combined coordination dominates a regime in which only monetary policy is coordinated. Given that combined coordination is the optimal policy regime, the choice of exchange rate regime becomes immaterial due to their equivalence. Therefore, the optimal regime in the face of a common productivity shock is one of combined coordination with the choice of exchange rate regime being immaterial.

Now consider the case of an asymmetric demand shock. It can be shown that in the absence of fiscal policy coordination, domestic (foreign) fiscal policy is more contractionary (expansionary) under a fixed exchange rate regime. As discussed above, under a fixed exchange rate the optimal response by the domestic monetary authority, who optimizes the joint social loss function, is to keep domestic credit unchanged. Therefore, fiscal policy must carry the entire stabilization burden.

Comparison of the inflation and employment outcomes in (12) and (20) are in general

ambiguous. However, it can be shown that as B > 1/2, that is as the economy becomes more

"7 This result supports Canzoncri and Gray (1985) and Laskar (1993) who show that in the face of a symmetric

shock a fixed exchange rate regime, in which monctary coordination is implicit, is welfarc-supcrior to a

flexible exchange rate regime in which monctary policics arc chosen noncoopcrativcly. However. our result

depends on the different cndogenous response of fiscal policy between the two exchange rate regimes rather than

on the behavior of monctary authoritics. This result supports Laskar (1993) who finds that monetary coordination under a flexible exchanye rate is

equivalent to a fixed exchange rate.

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open, the variance of inflation is higher under a flexible exchange rate. This is due to the identically opposite effect that the demand shock under a fixed exchange rate has on the domestic and foreign price. When B = 1/2, the lower foreign price just offsets the higher domestic price so that the consumer price indices are unchanged. In addition, as B > 1/2 the variance of employment is higher under a fixed exchange rate regime. Substituting the expressions in (12) and (20) into the social loss functions reveals that the social loss is higher under a fixed exchange rate. Therefore, a flexible exchange rate is the optimal exchange rate regime in the absence of fiscal policy coordination.

The comparisons discussed above hold also under combined coordination. Therefore, we can conclude that regardless of the policy regime, a flexible exchange rate dominates a fixed exchange rate. This makes intuitive sense given that the shock is asymmetric. Given that a flexible exchange rate is the optimal exchange rate choice, combined coordination dominates a regime in which only monetary policy is coordinated. Therefore, the optimal regime in the face of an asymmetric demand shock is one of combined coordination under flexible exchange

rates.

5. Conclusion

In the above analysis, we employed a simple model to further our understanding of the optimal stabilization policy when two countries can credibly commit to monetary and fiscal policy coordination. Our general conclusion is that given the exchange rate regime and given the stociastic disturbance, a regime of monetary and fiscal policy coordination between symmetric countries should always be chosen over a regime in which only monetary policy is coordinated. However, given the choice of monetary and fiscal policy coordination, the desirability of the exchange rate regime depends on the stochastic disturbance. If the disturbance is a common supply shock, the choice of exchange rate regime is immaterial.

However, if the disturbance is an asymmetric demand shock, a flexible exchange rate should be

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chosen over a fixed exchange rate. Therefore, as the prevalence of asymmetric shocks increases, the more desirable a flexible exchange rate becomes.

In the context of the European Community, Bayoumi and Eichengreen (1992) show that the shocks affecting EC countries are significantly more idiosyncratic than the shocks affecting the United States. The above analysis suggests that monetary and fiscal policy coordination under a flexible rate may be the optimal stabilization policy for EC countries. However, the desire to fix exchange rates among EC countries is based on many considerations other than optimal stabilization policy. Now that the Maastricht Treaty has been ratified by all twelve EC member states, the inexorable march toward fixed exchange rates will continue although as the recent widening of fluctuation bands suggest, the journey may be far from smooth.

Given that exchange rates among EC countries inevitably will be fixed, the above analysis holds other relevance for EMU. If fiscal policies are coordinated under fixed exchange rates and if the shocks that hit EC countries are mainly common productivity shocks, then fiscal policy flexibility is relatively unnecessary; the common monetary policy can act as the common stabilization policy. However, if the shocks that hit EC countries are mainly asymmetric demand shocks, fiscal policy flexibility is desirable. Moreover, fiscal policy coordination, which the Maastricht Accord explicitly mandates, requires even more policy flexibility than insular fiscal policymaking. Therefore, limits on the flexibility of fiscal

policies, as suggested in the Delors Report, may hinder macroeconomic stabilization.

19

Appendix: Derivation of Employment and Supply Curves

The production function is = ni&o) Y,=N, 0X, O<ay<1 (Al)

where capital letters represent the level of a variable. Setting the marginal productivity

of labor equal to the real wage and rearranging yields approximately the demand for labor n= 1 (P,- w, + x,) a, = I/(1-a9) (A2) The supply of labor is

n= (w, -¢,) A>0 (A3)

t

where C the consumer price index, can be written

c, = (1-B)p, + Bip, +e) 0<B<05 (A4)

where e, is the nominal exchange rate expressed in units of domestic currency per unit of foreign currency. Equating (A2) and (A3) and rearranging yields the market-clearing wage

AB Z, +

W,=p,+ t ‘a, +a! a

al x (AS) +2

l

where Z, is the real exchange rate. We assume that in time period t-1 workers and firms

t negotiate the wage rate that will prevail in time period t to be the expected market-clearing rate. Workers will then supply whatever labor is demanded at that wage rate. Because we

assume all shocks are white noise, the negotiated wage rate is

w= () (A6)

Substituting (A6) into (A2) yields employment n= a1 (P, + XK) (A7) and substituting (A7) into the logarithmic transformation of (A1) yields the supply function

given in the text where a = Gy/(1-a9). An analogous derivation produces the foreign supply

Curve.

20

REFERENCES

Bayoumi, Tamin and Eichengreen, Barry, "Shocking Aspects of European Monetary Unification,” Centre for Economic Policy Research Discussion Paper #643, May 1992

Bryson, Jay, Jensen, Henrik and VanHoose, David, "Rules, Discretion, and International Monetary and Fiscal Policy Coordination, Open Economies Review 4 (1993), p. 117-132

Canzoneri, Matthew and Gray, Jo Anna, "Monetary Policy Games and the Consequences of Non- Cooperative Behavior", International Economic Review 26 (October 1985), p. 547-564

Canzoneri, Matthew and Henderson, Dale, "Is Sovereign Policymaking Bad?", Carnegie-Rochester Conference Series on Public Policy #28, North-Holland, Amsterdam, 1988

Canzoneri, Matthew and Henderson, Dale. Monetary Policy in Interdependent Economies: A Game- Theoretic Approach, The MIT Press, Cambridge, MA, 1991

Cohen, Daniel and Wyplosz, Charles, "The European Monetary Union: An Agnostic Evaluation", in Ralph Bryant, David Currie, Jacob Frenkel, Paul Masson, and Richard Portes (eds.),

Macroeconomic Policies in an Interdependent World, The Brookings Institution, Washington DC, 1989

Commission of the European Commiunities, Report on Economic and Monetary Union in the European Community, Luxembourg, 1989

Currie, David, Levine, Paul and Pearlman, Joseph, "European Monetary Union or Hard EMS?", European Economic Review 36 (August 1992), p. 1185-1204

De Grauwe, Paul, "Fiscal Policies in the EMS - A Strategic Analysis", in Emil-Maria Claassen (ed.), International and European Monetary Systems, Praeger, New York, 1990)

Kehoe, Patrick, "Coordination of Fiscal Policies in a World Economy", Journal of Monetary Economics 19 (1987), p. 349-376

Laskar, Daniel, "The Role of a Fixed Exchange Rate System When Central Bankers Are Independent”, Journal of International Money and Finance 12 (June 1993), p. 319-331

Sheen, Jeffrey, "International Monetary and Fiscal Policy Cooperation in the Presence of Wage

Inflexibilities: Are Both Counterproductive?", Journal of Economic Dynamics and Control 16 (April 1992), p. 359-387

Turnovsky, Stephen, "The Gains From Fiscal Cooperation in the Two-Country Real Trade Model", Journal of International Economics 25 (1988), p. 111-127

van der Ploeg, Frederick, "Fiscal Stabilisation and Monetary Integration in Europe: A Short- Run Analysis", De Economist 140 (1992), p. 16-43

von Hagen, Jiirgen and Fratianni, Michele, "Policy Coordination in the EMS with Stochastic Asymmetries”, in Clas Wihlborg, Michele Fratianni, and Thomas Willett (eds.), Financial Regulation and Monetary Arrangements After 1992, North-Holland, Amsterdam, 1991

IFDP

Number

453

452

45

450) 449

448

447

446

445

444

445

442

44]

440)

21

International Finance Discussion Papers

Titles

1993 Macroeconomic Stabilization Through Monetary and Fiscal Policy Coordination: Implications for European Monetary Union

Long-term Banking Relationships in General Equilibrium

The Role of Fiscal Policy in an Incomplete Markets Framework

Internal Funds and the Investment Function

Measuring International Economic Linkage with Stock Data

Macroeconomic Risk and Asset Pricing: Estimating the APT with Observable Factors

Near observational equivalence and unit root processes: formal concepts and implications

Market Share and Exchange Rate Pass-Through in World Automobile Trade Industry Restructuring and Export Performance:

Evidence on the Transition in Hungary

Exchange Rates and Foreign Direct Investment: A Note

Global versus Country-Specific Productivity Shocks and the Current Account

The GATT’s Contribution to Economic Recovery in Post-War Western Europe

A Utility Based Comparison of Some Models of Exchange Rate Volatility

Cointegration Tests in the Presence of Structural Breaks

Author(s)

Jay H. Bryson

Michael S. Gibson

Charles P. Thomas

Guy V.G. Stevens

John Ammer Jianping Mei

John Ammer

Jon Faust

Robert C. Feenstra Joseph E. Gagnon Michael M. Knetter

Valerie J. Chang Catherine L. Mann

Guy V.G. Stevens

Reuven Glick

Kenneth Rogoff

Douglas A. Irwin

Kenneth D. West Hali J. Edison Dongchul Cho

Julia Campos Neil R. Ericsson David F. Hendry

Please address requests for copies to International Finance Discussion Papers, Division of International Finance, Stop 24, Board of Governors of the Federal Reserve System, Washington, D.C. 20551.

I-DP Number

439

438

437

436

435

434

433

432

43]

430)

429

428

427

426

International Finance Discussion Papers

Life Expectancy of International Cartels: An Empirical Analysis

Daily Bundesbank and Federal Reserve Intervention and the Conditional Variance Tale in DM/$-Returns

War and Peace: Recovering the Market's Probability Distribution of Crude Oil Futures Prices During the Gulf Crisis

Growth, Political Instability, and the Defense Burden

Foreign Exchange Policy, Monetary Policy, and Capital Market Liberalization in Korea

The Political Economy of the Won: U.S.-Korean Bilateral Negotiations on Exchange Rates

Import Demand and Supply with Relatively Few Theoretical or Empirical Puzzles

The Liquidity Premium in Average Interest Rates

The Power of Cointegration Tests

The Adequacy of the Data on U.S. International Financial Transactions: A Federal Reserve Perspective

Whom can we trust to run the Fed? Theoretical support for the founders views

Stochastic Behavior of the World Economy under Alternative Policy Regimes

Real Exchange Rates: Measurement and Implications for Predicting U.S. External Imbalances

Central Banks’ Use in East Asia of Money Market Instruments in the Conduct of Monetary Policy

Jaime Marquez

Geert J. Almekinders Sylvester C.W. Eijffinger William R. Melick Charles P. Thomas Stephen Brock Blomberg Deborah J. Lindner Deborah J. Lindner

Andrew M. Warner

Wilbur Jonn Coleman I Christian Gilles Pamela Lzbadie

Jeroen J.M. Kremers Neil R. Ericsson Juan J. Dolado

Lois E. Stekler Edwin M. Truman

Jon Faust

Joseph E. Gagnon

Ralph W. Tryon

Jaime Marquez

Robert F. Emery