Insulation Impossible: Fiscal Spillovers in a Monetary Union - Dallas Fed

This paper studies the effects of monetary policy rules in a monetary union. The focus of the analysis is on the interaction between the fiscal policy of member countries (regions) and the central monetary authority. When capital markets are integrated, the fiscal policy of one country will influence equilibrium wages and interest rates. Thus there are fiscal spillovers within a federation. The magnitude and direction of these spillovers, in particular the presence of a crowding out effect, can be influenced by the choice of monetary policy rules. We find that there does not exist a monetary policy rule which completely insulates agents in one region from fiscal policy in another. Some familiar policy rules, such as pegging an interest rate, can provide partial insulation. JEL codes: E6, F33, F36 * Russell Cooper, Department of Economics, BRB, 2.102A, University of Texas, Austin, Texas 78712. 512-475-8704. [email protected]. Hubert Kempf, Direction de la Recherche, Banque de France, 31, rue Croix des Petits Champs 75049, Cedex 01 France. +01-4297-7373. [email protected]. Dan Peled, University of Haifa, Department of Economics, Mount Carmel, Haifa 31905, Israel. +972-4-8240084. [email protected]. The views expressed in this paper are those of the authors and do not necessarily reflect the views of the Banque de France, the Federal Reserve Bank of Dallas or the Federal Reserve System. Insulation Impossible: Fiscal Spillovers in a Monetary Union∗ Russell Cooper†, Hubert Kempf‡, and Dan Peled§