Optimal Monetary and Fiscal Policy in the EMU: Does Fiscal Policy Coordination matter?

I develop and analyze a DSGE model of a currency union to revise the question of how to conduct monetary and fiscal policy in countries that share the same currency. In contrast with the previous literature which assumes coordination, this paper analyzes the case where coordination lacks among fiscal authorities as well as between fiscal and monetary authorities. I show that the normative prescriptions emphasized by former analyses are not valid any more once policymakers are not coordinated. Indeed, in that case the common central bank does not stabilize the average union in ation as if it were in a closed economy because it has to take into account the distortions caused by the lack of coordination among fiscal policymakers. At the same time, if there is not a common agreement to coordinate fiscal policies, autonomous governments should use government expenditure as a stabilization tool even if shocks are symmetric.