On the Nature of Conflicts between Central Banks and National Governments in a Monetary Union

Output-growth and inflation differentials have been large and rather persistent since the beginning of the European Economic and Monetary Union. In the empirical literature, several fundamental causes of heterogeneities as regional productivity shocks and home-bias effects, and frictions as staggered-pricing and labor immobility are identified as causes for these differentials. In our model, we analyze a twocountry monetary union while incorporating those frictions and heterogeneities. We show that welfare-maximizing countrywide fiscal policy should aim at stabilizing domestic output and domestic producer-price inflation (PPI). The common central bank considers the union as a whole. This leads to conflicts in achieving the optimal targets, as we have a higher number of target variables than instruments in the monetary union. JEL-classification: E52, E61, F42