Monetary and Fiscal Policy Interactions in a Monetary Union with Country-size Asymmetry

Abstract

This paper analyses optimal discretionary non-coordinated monetary and fiscal stabilization policies in a micro-founded New-Keynesian model of a two-country monetary union with country-size asymmetry, under two policy scenarios. A balanced-budget policy scenario and a policy scenario where the presence of government debt limits the macroeconomic stabilization effort and enlarges the sources of strategic policy interactions. Numerical results indicate that non-cooperation exacerbates the fiscal policy activism of a small country while moderating that of a large country. In the balanced-budget scenario, non-cooperation improves (reduces) welfare for a small (large) country while, in the high-debt scenario, it produces the opposite results. Cooperation dominates non-cooperation for the union as a whole.Monetary union; optimal fiscal and monetary policies; asymmetric countries.