Monetary unions with heterogeneous fiscal space

Abstract

This paper develops a multi-country Heterogeneous-Agent New Keynesian (HANK) model of a monetary union with ex-ante heterogeneity in legacy public debt across member states. We calibrate the model to the euro area and show that, following symmetric aggregate shocks, the systematic monetary policy reaction induces heterogeneous national outcomes, driven by differences in fiscal space. This generates a trade-off between union-wide macroeconomic stabilization and cross-country synchronization of economic activity for the central bank. We characterize a possibility frontier between union-wide inflation stability and cross-country synchronization, which is traced out by varying the degree of the central bank’s hawkishness towards inflation. We study the role of deficit caps, fiscal and political unions, and augmented Taylor rules as instruments to navigate the stabilization–synchronization trade-off.