Browsing by Subject "Strategic Interaction"

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On the blurring boundaries between monetary and fiscal policy
(2025) Krautter, Victoria; Evers, Michael
In recent decades, several different crises have occurred in the European monetary union at ever shorter intervals. In a monetary union, the centralised monetary policy makes it difficult for member states to react to crises, as only national fiscal policy can be used to combat such crises. This is particularly problematic in the case of asymmetric shocks between member states, because in a monetary union, centralised monetary policy can only react efficiently to symmetric shocks. However, the national asymmetric effects of shocks must be balanced out by national fiscal policy. This makes the role of fiscal policy all the more crucial in the monetary union. Therefore, the interaction between monetary and fiscal policy in a monetary union is essential and must be further explored. As part of my dissertation, I am examining the interaction between monetary and fiscal policy in a monetary union and looking at the effects of different fiscal instruments. I use a dynamic stochastic general equilibrium model with a large fiscal sector for two regions to investigate the introduction of different fiscal instruments in a monetary union. National fiscal policy can cause negative adverse effects between member countries. A national strategically used tax policy of one country can have negative effects on another country, since a country will always try to maximise its own welfare exclusively. This is reflected in the "beggar-thy-neighbour" effect. In the first two projects of my thesis, the question is whether the strategic exploiting of a labour tax rate can be reduced by transfer regimes or public debt arrangements. To this end, a case of pure centralised monetary policy with a strategically used labour tax is compared with the respective introduced fiscal regimes. The additional fiscal transfer regimes include a tax revenue sharing mechanism between the countries and a central fiscal authority that covers indirect transfers between the member countries. A linear debt restriction and a central authority with a common union-wide debt represent the fiscal public debt mechanisms. In order to be able to identify the strategic component of the labour tax rate across all considered regimes, the differences between the Nash equilibrium and the social planner solution are determined. The strategic interaction requires welfare losses and determines an inefficient allocation of resources in the monetary union. Fiscal instruments can partially internalise these strategic incentives and achieve a more efficient allocation. These two projects were co-authored with Prof. Dr. Michael Evers and Julius Kraft. In my third project, I consider a currency union with a central monetary policy in combination with a government debt and a primary deficit limitation rule based on the model of the Maastricht Treaty. This situation is expanded and compared using different transfer regimes such as the tax revenue sharing mechanism and a central fiscal authority with indirect transfers. In addition, the functionality of the primary deficit and government debt rule is analysed with regard to different shocks in the form of an asymmetric productivity and an asymmetric government spending. These additional fiscal rules aim to prevent negative spillover between the two regions due to over-indebtedness and excessive primary deficits. For this purpose, the two restrictions on the primary deficit and the national government debt are described by an exponential function in order to be able to model a one-sided punishment for non-compliance with the respective target values. This guarantees that larger exceedances of the target values are punished more severely than small deviations. In addition, undershoots of the target value are only punished very slightly. This can guarantee greater discipline in compliance with the fiscal rules. The fiscal arrangements can reduce the strategic usage of the labour tax rate compared to a scenario with purely centralised monetary policy. This applies in particular to a central fiscal authority, which can decline the labour tax rate overall. Fiscal arrangements can help diminish strategic incentives and thereby create more efficient allocation. However, this effect is weaker if the model frictions such as distorting taxes, nominal rigidities and mark-ups are neglected. Nevertheless, the fiscal regimes lead to a reduction in the strategic component in the labour tax rate, whereby either the tax base effect or the national debt effect can be reduced. The primary deficit restriction in conjunction with the transfer regimes has a significantly limited effectiveness under the presence of an asymmetric government spending shock although transfers decrease the level of the primary deficit. In contrast, the government debt limitation is actually effective under all regimes and assumed shocks. The punishment of excessive government debt can prevent over-indebtedness. Its functionality is reinforced by the sovereign spread on government debt working as a market discipline mechanism. This is especially true for a central fiscal authority. The interregional risk-sharing in a monetary union enables the member states to protect each other against asymmetric shocks. The transfer regimes with an additional debt and primary deficit restriction diminish income risk-sharing significantly. However, pure transfer or debt regimes without an additional fiscal limitation lead to a substantial increase in the risk-sharing of consumption and income. This strengthens the international insurability of the monetary union as a whole. Although this characteristic is predominantly pronounced for a central fiscal authority with common union-wide debt and indirect transfers. The combination of a primary deficit and government debt restriction rule with the two transfer regimes results in an improvement in welfare compared to a pure centralised monetary policy with a debt and deficit limitation. The strategic exploiting of the labour tax rate reduces the welfare level for all scenarios. The exclusion of this strategic component, on the other hand, always increases the welfare level significantly. This applies regardless of whether a pure centralised monetary policy or a fiscal scenario like transfers or debt restriction is considered. The central fiscal authority has the greatest welfare gains of all considered arrangements. In conclusion, a government debt limitation rule with all regarded transfer scenarios and centralised monetary policy are effective for the observed shocks. The central fiscal authority is particularly characterised by the reduction of the strategic incentives in the labour tax rate, a significant improvement in the interregional risk-sharing and obviously welfare gains. Thus, the highest level of fiscal integration leads to the best results based on the assumed criteria. Both monetary policy and fiscal policy should be centralised in order to achieve the best possible solution for the monetary union as whole.