We lay out a tractable model for fiscal and monetary policy analysis in a currency union, and study its implications for the optimal design of such policies. Monetary policy is conducted by a common central bank, which sets the interest rate for the union as a whole. Fiscal policy is implemented at the country level, through the choice of government spending. The model incorporates country-specific shocks and nominal rigidities. Under our assumptions, the optimal policy requires that inflation be stabilized at the union level by the common central bank. On the other hand, the relinquishment of an independent monetary policy, coupled with nominal price rigidities, generates a stabilization role for fiscal policy, one beyond the efficient provision of public goods. Interestingly, the stabilizing role for fiscal policy is shown to be desirable not only from the viewpoint of each individual country, but also from that of the union as a whole

There is ample evidence that the frequency of price adjustments differs substantially across sectors. This paper introduces sectoral heterogeneity in price stickiness into an otherwise standard sticky price model to study how it affects the dynamics of monetary economies. Qualitative and quantitative results from a realistic calibration for the U.S. economy show that monetary shocks tend to have larger and more persistent real effects in heterogeneous economies, when compared to identical-firms economies with similar degrees of nominal and real rigidity. In the presence of strategic complementarities in price setting, sectors with lower frequencies of price adjustment have a disproportionate effect on the aggregate price level. In order to better approximate the dynamics of the calibrated heterogeneous economy, an identical-firms model requires a frequency of price changes that is up to three times lower than the average of the heterogeneous economy.

This paper addresses the question of the joint conduct of fiscal and monetary policy in a currency union. The problem is studied using a two-country DSGE framework with staggered price setting, monopolistic competition in the goods market, distortionary taxation and nominal debt. The two countries form a cur-rency union but retain fiscal policy independence. The policy problem can be cast in terms of a tractable linear-quadratic setup. The stabilization properties and the welfare implications of the optimal commitment plan are compared with the outcome obtained under simple implementable rules. The central result is that fiscal policy plays a key role to smooth appropriately the impact of idiosyn-cratic exogenous shocks. Fiscal rules that respond to a measure of real activity have the potential to approximate accurately the optimal plan and lead to large welfare gains as compared to balanced budget rules. Monetary policy shall focus on maintaining price stability. JEL Classification: E63, F33, F42 Key Words: LQ Approximation, Optimal Policy, Flexibility, Welfare ∗I would like to thank Pierpaolo Benigno and Mark Gertler for their guidance and valuable advice. I am indebted to Liz Potamites for reading an early draft of this paper. Part of this project has been completed while visiting the Monetary Policy Strategy division at the European Central Bank. I have especially enjoyed conversations with Filippo Altissimo, Matt Canzoneri, Bezah Diba,

inflation targets as the defining principle that should guide the conduct of monetary policy. This development is often credited with having brought about substantial reductions in both the level and variability of inflation in the inflation-targeting countries, and is sometimes argued to have improved the stability of the real economy as well. 1 Inflation-forecast targeting, as a systematic decision procedure for the conduct of monetary policy, was developed at central banks like the Reserve Bank of New Zealand, the Bank of Canada, the Bank of England, and the Bank of Sweden on a trial-and-error basis, with little guidance from the academic literature on monetary policy rules. But the growing popularity of inflation targeting has more recently led to an active literature that seeks to assess the desirability of such an approach from the standpoint of theoretical monetary economics. This literature finds that an optimal policy regime — one that could have been designed on a priori grounds to achieve the highest possible degree of social welfare — might well be implemented through procedures that share important features of the inflation-forecast targeting

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Emerging market economies often face sudden stops in capital inflows or reduced access to the international capital market. This paper analyzes what should monetary policy do in such an event. Optimal monetary policy induces a hike in interest rate and exchange rate depreciation. The latter mitigates the impact of the sudden stop in the domestic economy by boosting export revenues. In spite of that, a recession is not avoided. It is shown in the paper that the arrival of the sudden stop further increases the problem of time inconsistency of policy. Optimal policy is fairly well approximated by a flexible targeting rule, in which a combination of domestic prices, exchange rate and output is stabilized. We show that whether a fixed exchange rate regime is a good policy strategy, from a welfare perspective, depends on the economic environment. For the benchmark parameterization, the peg is the worst of simple rules considered. For alternative parameterizations, featuring low nominal rigidities or high elasticity of foreign demand, the fixed exchange rate regime performs relatively better.

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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

This paper, first, develops and estimates a stochastic dynamic general equilibrium (SDGE) model with sticky prices and wages for the euro area. The model incorporates various other features such as habit formation, costs of adjustment in capital accumulation and variable capacity utilisation and is estimated using seven key macro-economic variables: GDP, consumption, investment, prices, real wages, employment and the nominal interest rate. The introduction of eight orthogonal structural shocks (including productivity, labour supply, preference, cost-push and monetary policy shocks) allows for an empirical investigation of the effects of such shocks and of their contribution to business cycle fluctuations in the euro area. For example, it is found that productivity shocks account for only 10 percent of the long run variance in output. Using the estimated model, the paper then analyses the output (real interest rate) gap, defined as the difference between the actual and the flexible-price level of output (real interest rate). Finally, the estimated model is also used to analyse optimal monetary policy.

Abstract. We estimate a New-Neoclassical Synthesis business cycle model with two investment shocks. The …rst, an investment-speci…c technology shock, a¤ects the transformation of consumption into investment goods and is identi…ed with the relative price of investment. The second shock a¤ects the production of installed capital from investment goods or, more broadly, the transformation of savings into the future capital input. We …nd that this shock is the most important driver of U.S. business cycle ‡uctuations in the post-war period and that it is likely to proxy for more fundamental disturbances to the functioning of the …nan-cial sector. To corroborate this interpretation, we show that it is closely related to interest rate spreads and that it played a particularly important role in the recession of 2008-09.