Discretionary Policy in a Monetary Union with Sovereign Debt

This paper examines the interactions between multiple national …scal policymakers and a single monetary policy maker in response to shocks to government debt in some or all of the countries of a monetary union. We assume that national governments respond to excess debt in an optimal manner, but that they do not have access to a commitment technology. This implies that national …scal policy gradually reduces debt: the lack of a commitment technology precludes a random walk in steady state debt, but the need to maintain national competitiveness avoids excessively rapid debt reduction. If the central bank can commit, it adjusts its policies only slightly in response to higher debt, allowing national …scal policy to undertake most of the adjustment. However if it cannot commit, then optimal monetary policy involves using interest rates to rapidly reduce debt, with signi…cant welfare costs. We show that in these circumstances the central bank would do better to ignore national …scal policies in formulating its policy. Acknowledgement 1 This paper was prepared for presentation at the EER Symposium, Philadelphia June 2010. We are grateful for …nancial support from the ESRC, Grant No. RES-062-23-1436, but the views expressed here are entirely our own. We are also grateful for helpful comments from Eric Leeper, Jim Nason, Paolo Pesenti, Chris Sims, Leopold von-Thadden and participants at the Symposium. Address for correspondence: Campbell Leith, Department of Economics, University of Glasgow, Adam Smith Building, Glasgow G12 8RT. E-mail [email protected]. 1 Overview What is the optimal response of the European Central Bank’s (ECB) monetary policy to a positive shock to government debt in its member countries? This will depend on how national …scal policy responds to its own excess debt, which we show is likely to be quite di¤erent to how it would respond outside of a monetary union. We analyse a multi-country monetary union where national …scal authorities operate in the national interest and do not have access to a commitment technology. This alters the analysis of optimal monetary and time-consistent …scal policy in closed economies in various respects. First, an e¤ective means of in‡uencing debt levels in the closed economy (or in the open economy under ‡exible exchange rates) is to introduce in‡ation surprises under ‡exible prices, or to reduce real debt service costs under sticky prices. Within a monetary union national policy makers no longer have access to monetary policy to achieve this, and any in‡ation consequences of changes in distortionary taxes will have repercussions on competitiveness with respect to the rest of the monetary union and will ultimately have to be undone. Thus the extent of the time-inconsistency problem can be quite di¤erent in the monetary union, relative to the closed economy. Secondly, while the national …scal authorities are assumed to be too small to interact strategically with each other or the European Central Bank (ECB), the ECB could reasonably be thought to be aware of how national …scal authorities might react to union-wide economic conditions and may or may not choose to factor this into their optimal policies. We therefore explore how time-consistent national …scal policies in‡uence ECB behaviour, after allowing for varying degrees of ECB conservatism, ECB mandates and whether or not the ECB can commit. We show that even when national …scal policies are sound and collectively stabilise union-wide debt stocks, the ECB faces a signi…cant temptation to adjust monetary policy to facilitate national …scal adjustment and this time-inconsistency problem can be particularly costly in welfare terms. In terms of modelling, we follow Gali and Monacelli (2008) in considering the case of monetary union consisting of a continuum of small economies, although we extend GM’s analysis to include a labour income tax, in addition to government spending, as a national …scal instrument. More signi…cantly, we also focus on the need to satisfy national government budget constraints through adjustments in distortionary taxes and/or government spending conditional on the monetary policies pursued by the ECB.1 We assume that national …scal authorities seek to maximise national welfare, taking the ECB’s monetary policy and the state of the rest of the union as given. Additionally, we assume that the national …scal authorities do not have access to a commitment technology such that their national …scal policies are constrained to be time-consistent. The resultant optimal national policies successfully stabilise national government debt gradually through a combination of government spending cuts and tax rises, which are carefully balanced to mitigate the costs of lost competitiveness rel1GM assume that national governments have access to a lump-sum tax at all points in time such that government debt does not play any part in their analysis.