Optimal Fiscal Rules in a Monetary Union

Abstract

This paper investigates the importance of fiscal policy in providing macro-economic stabilization in a monetary union. We use a microfounded NewKeynesian model of a monetary union, which incorporates persistence ininflation and non-Ricardian consumers, and derive optimal simple rules forfiscal authorities. We find that fiscal policy can play an important role inreacting to inflation, output, and the terms of trade, but that not much is lostif national fiscal policy is restricted to react, on the one hand, tonationaldifferencesin inflation and, on the other hand, to either national differencesin output or changes in the terms of trade. However, welfare is reduced ifnational fiscal policy responds only to output, ignoring inflation.