Is fiscal policy coordination desirable for a monetary union? An assessment from the perspective of a small open economy

Abstract

Motivated by the recent experience of Greece and other relatively small European Monetary Union members, this paper examines the appeal of taking part in a large monetary union from the perspective of small open economies. We show that in the absence of fiscal policy considerations, taking part in a large monetary union is counterproductive for a small economy. Nevertheless, once the role of fiscal policy is properly incorporated, taking part in the monetary union becomes desirable from a social perspective. Following these results, we explore the prospects of engaging both economies in fiscal coordination and on how different schemes of policy synchronization can provide the grounds to make cooperation beneficial for the members of a monetary union. We find that when monetary and fiscal authorities cooperate and attempt to exploit externalities for their own benefit, a Pareto efficient outcome can be achieved if fiscal policy in the monetary union is coordinated by a central authority and such authority acts as a the Stackelberg leader vis-à-vis the central bank. Our analysis suggests that this regime is superior to (i) a monetary union in which fiscal authorities conduct their policy in an independent or (ii) coordinated fashion, (iii) a regime where both authorities internalize the effects of their own externalities by allowing the central bank to act as Stackelberg leader and (iv) a regime in which the small open economy decides to stay out of the monetary union.