Monetary and Fiscal Policy Design under EMU: A Dynamic Game Approach

The European Union (EU) countries have started the Economic and Monetary Union (EMU) on January 1, 1999. With the EMU, the EU countries replaced their national currencies and national monetary policy autonomy by a common currency, the Euro, and a common monetary policy that is designed and implemented by the European Central Bank (ECB). A common currency was considered to form the completion of the Single Market Program: in fully liberalized internal goods, labor and capital markets, a common currency is a natural counterpart and expected to deliver substantial efficiency gains. The distinguishing feature of the EMU is that of a full monetary union without being accompanied by a political and fiscal union. The ECB sets the monetary policy for the Euro area. In ECB (1998) the institutional framework and monetary policy objectives and instruments (and procedures) of the ECB are proposed. The primary objective is to secure price stability. As long as it does not interfere with price stability, the ECB also targets real macroeconomic activity in the Euro area (which generally will be macroeconomic stabilization). The monetary policy strategy will combine a monetary targeting and an inflation targeting strategy for the Euro area and is likely to be implemented in a pragmatic way, reflecting actual practice. At the end of 1998, reference growth rates for inflation and broad money, M3, in the area were set at 2 percent and 4.5 percent, respectively. In order to achieve its objectives it has at its disposal a set of instruments that can be used. The fact that the ECB conducts monetary policy for a composite of 11 sovereign countries implies that the transmission of monetary policy is much more complicated than that in case of a monetary policy