On optimal monetary and fiscal policy interactions in open economies

This paper studies monetary and fiscal policy interactions in a two country model, where taxes on firms’ sales are optimally chosen and the monetary policy is set cooperatively. It turns out that in a two country setting non-cooperative fiscal policy makers have an incentive to change taxes on sales depending on shocks realizations in order to reduce output production. Therefore whether the fiscal policy is set cooperatively or not matters for optimal monetary policy decisions. Indeed, as already shown in the literature, the cooperative monetary policy maker implements the flexible price allocation only when special conditions on the value of the distortions underlying the economy are met. However, if non-cooperative fiscal policy makers set the taxes on firms’ sales depending on shocks realizations, these conditions cannot be satisfied; conversely, when fiscal policy is cooperative, these conditions are fulfilled. We conclude that whether implementing the flexible price allocation is optimal or not depends on the fiscal policy regime.Monetary and Fiscal Policy, Policy Coordination

Optimal Monetary and Fiscal Policy in the EMU: Does Fiscal Policy Coordination matter?

I develop and analyze a DSGE model of a currency union to revise the question of how to conduct monetary and fiscal policy in countries that share the same currency. In contrast with the previous literature which assumes coordination, this paper analyzes the case where coordination lacks among fiscal authorities as well as between fiscal and monetary authorities. I show that the normative prescriptions emphasized by former analyses are not valid any more once policymakers are not coordinated. Indeed, in that case the common central bank does not stabilize the average union in ation as if it were in a closed economy because it has to take into account the distortions caused by the lack of coordination among fiscal policymakers. At the same time, if there is not a common agreement to coordinate fiscal policies, autonomous governments should use government expenditure as a stabilization tool even if shocks are symmetric.Monetary and Fiscal Policy, Policy Coordination

On the Benefits of a Monetary Union: does it pay to be bigger?

A two area dynamic stochastic general equilibrium model is employed to investigate the welfare implications of losing monetary independence. Two policy regimes are compared: (i) in one area there is a common currency, while in the other area countries still retain their autonomous monetary policy; (ii) there are two monetary unions. When chosen by national authorities, monetary policy can stabilize optimally the effects of country-specific shocks. However, in that case, policy decisions internalize neither the spillover effects on consumers living in the same area nor their impact on the world economy. Thus the adoption of a common currency implies a trade-off between the cost of not tailoring monetary policy to single country economic conditions and the gains entailed by the improvement upon the conduct of national monetary policies. Our results show that under markup shocks and plausible calibrations, there may be welfare gains from adopting a common currency.Optimal Monetary Policy, Currency Areas, Terms of Trade Externality

Risky Mortgages in a DSGE Model

This paper develops a DSGE model with housing, risky mortgages and endogenous default. Housing investment is subject to idiosyncratic risk and some mortgages are defaulted in equilibrium. An unanticipated increase in the standard deviation of housing investment produces a credit crunch where delinquencies and mortgage interest rates increase, lending is curtailed, and aggregate demand for non-durable goods falls. The economy experiences a recession as a consequence of the credit crunch. The paper compares economies that differ only in the riskiness of housing investment. Economies with lower risk are characterized by lower steady-state mortgage default rates and higher loan-to-value and leverage ratios. The macroeconomic effects of an unanticipated increase in housing investment risk are amplified in high-leverage economies. Monetary policy plays an important role in the transmission of housing investment risk, as inertial interest rate rules generate deeper output contractions.Housing, Mortgage default, Mortgage Risk

Mortgage Amortization and Amplification

Mortgages characterized by negative or low early amortization schedules amplify the macroeconomic effects of a housing risk shock. We analyze the role of mortgage amortization in a two-sector DSGE model with housing risk and endogenous default. Mortgage loan contracts extend to two periods and have adjustable rates. The fraction of principal to be repaid in the first period can vary. As the fraction of principal to be paid in the first period falls, steady-state mortgages and leverage increase and the impact of a housing risk shock on consumption and output is amplified. Borrowers prefer negative amortization. If free to choose the amortization schedule, borrowers would repay most of the principal in the last period of the contract. Low early repayments of principal allow borrowers to hold on to their housing stock and postpone default to the second period having incurred small sunk costs.Housing, Mortgage default, Mortgage risk

On the benefits of a monetary union: does it pay to be bigger?

This paper revisits the question of the appropriate domain of a currency area using a New-Keynesian open economy model in which the world is split into two areas, each framed as a continuum of small open regions. We show that the adoption of a common currency like the euro can be beneficial for the members of the monetary union, since the spill-over effects generated by the inflationary policies of the small open economies are likely to outweigh the costs of not tailoring monetary policy to country-specific shocks. We also show that while the enlargement of the monetary union to another group of small open economies can bring about welfare gains for all countries involved, monetary integration of two large economies, such as the euro area and the U.S., will not. These findings can help to rationalize the process of the creation and enlargement of multi-country currency areas like the eurozone

Trade Policy: Home Market Effect vs Terms of Trade Externality

We study trade policy in a two-sector Krugman type model of trade. We conduct a general analysis allowing for three different instruments: tariffs, export taxes and production subsidies. For each instrument we consider unilateral trade policy without retaliation. When carefully disentangling the different effects that determine policy makers' choices and modeling general equilibrium effects of taxes/tariffs, we find that production subsidies are always inefficiently low and driven by terms of trade effects. In the cases of tariffs and export taxes the home market effect prevails for some parameter combinations but mostly trade policy is determined by terms of trade effects and the desire to reduce distortions arising from monopolistic competition. Hence, our analysis sheds new light on trade policy in a model of intra-industry trade.Home Market Effect, Terms of Trade, Tariffs and Subsidies

Trade policy: home market effect versus terms of trade externality

We study trade policy in a two-sector Krugman-type trade model with home market effects. We conduct a general analysis allowing for three different instruments: tariffs, export taxes and production subsidies. For each instrument, we consider unilateral trade policy without retaliation. When carefully disentangling the different effects that determine policy makers’ choices and modeling general equilibrium effects of taxes/tariffs, we find – contrary to the results of previous studies – that production subsidies are always inefficiently low and driven by the incentives to improve the (welfare relevant) terms of trade. In the cases of tariffs and export taxes results depend crucially on whether the free trade allocation is efficient. When starting from an allocation that is distorted because of monopolistic competition, the home market effect (and in the case of export taxes also the desire to correct for the monopolistic inefficiency) induces policy makers to set a tariff (an export subsidy). However, when monopolistic distortions are corrected, terms of trade effects dominate the choice of trade policy and lead to an import subsidy (an export tax).home market effect, terms of trade, tariffs and subsidies

On the Benefits of a Monetary Union: does it pay to be bigger?

A two area dynamic stochastic general equilibrium model is employed to investigate the welfare implications of losing monetary independence. Two policy regimes are compared: (i) in one area there is a common currency, while in the other area countries still retain their autonomous monetary policy; (ii) there are two monetary unions. When chosen by national authorities, monetary policy can stabilize optimally the effects of country-specific shocks. However, in that case, policy decisions internalize neither the spillover effects on consumers living in the same area nor their impact on the world economy. Thus the adoption of a common currency implies a trade-off between the cost of not tailoring monetary policy to single country economic conditions and the gains entailed by the improvement upon the conduct of national monetary policies. Our results show that under markup shocks and plausible calibrations, there may be welfare gains from adopting a common currency

Optimal Monetary and Fiscal Policy in the EMU: Does Fiscal Policy Coordination matter?

I develop and analyze a DSGE model of a currency union to revise the question of how to conduct monetary and fiscal policy in countries that share the same currency. In contrast with the previous literature which assumes coordination, this paper analyzes the case where coordination lacks among fiscal authorities as well as between fiscal and monetary authorities. I show that the normative prescriptions emphasized by former analyses are not valid any more once policymakers are not coordinated. Indeed, in that case the common central bank does not stabilize the average union in ation as if it were in a closed economy because it has to take into account the distortions caused by the lack of coordination among fiscal policymakers. At the same time, if there is not a common agreement to coordinate fiscal policies, autonomous governments should use government expenditure as a stabilization tool even if shocks are symmetric