Overturning Mundell: Fiscal Policy in a Monetary Union

Central to ongoing debates over the desirability of monetary unions is a supposed trade-off, outlined by Mundell [1961]: a monetary union reduces transactions costs but renders stabilization policy less effective. If shocks across countries are sufficiently correlated, then, according to this argument, delegating monetary policy to a single central bank is not very costly and a monetary union is desirable. This paper explores this argument in a setting with both monetary and fiscal policies. In an economy with monetary policy alone, we confirm the presence of the trade-off and find that indeed a monetary union will not be welfare improving if the correlation of national shocks is too low. However, fiscal interventions by national governments, combined with a central bank that has the ability to commit to monetary policy, overturn these results. In equilibrium, such a monetary union will be welfare improving for any correlation of shocks. ∗We are grateful to the CNRS and the NSF for financial support. This is a much revised version of our working paper, Cooper and Kempf [2000]. The suggestions of two anonymous referees as well as the Managing Editor are appreciated. Comments from seminar participants at Boston College, Boston University, the Federal Reserve Bank of Cleveland, the Federal Reserve Bank of Minneapolis, McMaster University, the University of Pittsburgh, the European University Institute (Florence), CREST (INSEE), GREMAQ (Université de Toulouse), GREQAM (Université Aix-Marseille-II), Université de Lyon and EUREQua (Université Paris-1 Panthéon-Sorbonne) are gratefully acknowledged. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. 1. Overview Central to ongoing debates over the desirability and design of monetary unions is a supposed trade-off, outlined by Mundell [1961]: the gains to a monetary union arise from eliminating barriers to transactions while the costs reflect the reduced effectiveness of stabilization policy once monetary policy is delegated to a single central bank. Consequently, researchers study the correlation of shocks across economies in order to evaluate welfare gains from a monetary union. In his evaluation of the EMU, Feldstein [1997, p. 32] perfectly exemplifies this view: My own judgement is that, on balance, a European Monetary Union would be an economic liability. The gains from reduced transaction costs would be small and might, when looked at from the global point of view, be negative. At the same time, EMU would increase cyclical instability, raising the cyclical unemployment rate. This paper addresses two questions. Under what conditions does the Mundellian tradeoff exist? When is the correlation of shocks a useful metric for evaluating the welfare gains from a monetary union? We argue that the emphasis on this trade-off is misplaced because it ignores the significance of fiscal policy in determining the welfare gains from a monetary union. While the high correlation of shocks across countries is a sufficient condition for the existence of net gains to a monetary union, this condition is not necessary. Instead, once national fiscal policies are properly taken into account, the trade-off between stabilization losses and transaction cost reductions from a common currency disappears. In fact, a monetary union may be welfare improving regardless of the correlation of shocks. We study these issues in a multiple country, overlapping generations model. This model has two key ingredients which ultimately underlie our version of the Mundellian tradeoff. The first is risk sharing between unemployed and employed agents through unemployment insurance: this is the essence of “stabilization policy” in our environment. Whether there is a stabilization loss from a monetary union depends on how well these risks can be shared once monetary policy is delegated to a single central bank. Here the existence of country specific fiscal policy instruments is key. Second, to create potential gains to a monetary union from a reduction in trading frictions, there are agent specific taste shocks. As we shall see, these frictions can lead to a misallocation of resources in a multiple currency environment which is eliminated by a monetary union. This approach is quite different from Mundell [1961], which stressed price inflexibility in a static economy without any explicit representation of welfare and without any recognition of the vital importance of the interactions between fiscal and monetary policies. Our These issues are paramount in the so-called Delors report (Emerson et al., [1992]), which provided the official arguments in favor of EMU. These same points reappear in the analysis of the proposed North American Monetary Union as discussed by Buiter [1999]. framework is an explicit dynamic equilibrium structure which allows us to formally study these issues without assuming ad hoc decision rule for agents and policymakers. Further, we evaluate the welfare implications of a monetary union using the expected utility of agents in our economy. To evaluate the gains to a monetary union, we first study the equilibria of a multiple currency version of our model. In this economy, governments facilitate risk sharing between agents through monetary policy. Essentially an inflation tax is used to finance unemployment insurance. However, the presence of multiple currencies creates distortions in ex post consumption allocations across households. Due to cash-in-advance constraints, households make portfolio decisions prior to the realization of their tastes. Consequently, there are ex post welfare improving reallocations of consumption that cannot be realized in the multiple currency setting. We then consider a monetary union. The ex post distortions in consumption are eliminated by a monetary union because a common currency eliminates any portfolio choice. However, the delegation of monetary policy to a single central bank may be costly, as suggested by Mundell and the resulting literature, since stabilization policy may not be responsive enough to country specific circumstances. We find that only if shocks are sufficiently positively correlated across the countries will a monetary union increase welfare. This finding represents a formalization of the Mundellian trade-off but, notably, in an environment with flexible prices and stabilization policy through the provision of unemployment insurance. Once fiscal policy is properly incorporated into the analysis, the trade-off vanishes. More precisely, suppose the common monetary authority has the ability to act prior to national fiscal authorities. This strong central bank has commitment power vis-a-vis the national fiscal authorities. If the central bank holds the money supply constant and fiscal policy is used for internal stabilization, then risks are efficiently allocated within and across economies. Thus, the transactions gains to a common currency are realized without a stabilization loss. A monetary union is welfare increasing regardless of the correlation of shocks. We consider two extensions of the model to assess the robustness of these results. The first extension introduces price rigidity. This allows us to study the role of stabilization policy in terms of government actions to influence the levels of output and employment rather than its distribution between employed and unemployed agents. Here we confirm our findings: with adequate fiscal national policies, the Mundellian trade-off is not present, and a monetary union is welfare improving. We then use this structure to discuss a more general theme concerning the relationship between the imperfections to be addressed through stabilization policy and the set of tools available to policymakers. In the second extension, we dramatically weaken the commitment power of the single central bank: it is compelled to monetize the deficits of the independent fiscal authorities. Chari and Kehoe [1998] also point to the importance of commitment issues between members of a monetary union using a two-period reduced form model with government debt and money.