Spillovers of Regional Fiscal Policies in a Monetary Union∗

This paper studies the design of monetary policy 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. Thus each country perceives a gain to shifting its tax burden onto other federation members. When capital markets are integrated, the fiscal policy of one country can influence equilibrium prices. Monetary policies can be used to offset these effects. But, depending on the type of rule it adopts, such interventions by the monetary authority can facilitate a redistribution of the tax burden. Thus our analysis highlights the interplay between fiscal policy and monetary rules.