Monetary Rules and the Spillover of Regional Fiscal Policies in a Federation∗

This paper studies the effects of monetary policy rules in a fiscal federation, such as the European Union. The focus of the analysis is the interaction between the fiscal policy of member countries (regions) and the monetary authority. Each of the countries structures its fiscal policy (spending and taxes) with the interests of its citizens in mind. When capital markets are integrated, the fiscal policy of one country can influence equilibrium wages and interest rates. Under certain rules, monetary policy may respond to the price variations induced by regional fiscal policies. Depending on the type of rule it adopts, such interventions by the monetary authority can facilitate a redistribution of the tax burden across regions. Thus our analysis highlights the interplay between fiscal policy and monetary rules.