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The Optimal Monetary and Fiscal Policy Mix in a Financially Heterogeneous Monetary Union

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  • Jakob Palek

    (University of Kassel)

Abstract

Recent work on financial frictions in New Keynesian models suggest that there is a sizable spread between the risk-less interest rate and the borrowing rate. We analyze the optimal policy mix of monetary and fiscal authorities in a currency union with a country-specific credit spread by introducing a cost channel differential. The cost channel decreases the efficiency of monetary policy and increases the need for fiscal stabilization. We show that the importance of fiscal policy in stabilizing shocks increases, when there is a gap in the inflation differential due to a relative shock, an idiosyncratic shock or a credit spread differential. The welfare losses will be increasing (decreasing) in the size of the cost channel, if the nominal interest rate is a demand- (supply-) side instrument.

Suggested Citation

  • Jakob Palek, 2015. "The Optimal Monetary and Fiscal Policy Mix in a Financially Heterogeneous Monetary Union," MAGKS Papers on Economics 201506, Philipps-Universität Marburg, Faculty of Business Administration and Economics, Department of Economics (Volkswirtschaftliche Abteilung).
    • Handle: RePEc:mar:magkse:201506
    as

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    Cited by:

    1. Ian Hurst & Iana Liadze & Jack Meaning, 2016. "The monetary and fiscal framework of the EMU in times of high debt and constrained interest rates," National Institute of Economic and Social Research (NIESR) Discussion Papers 467, National Institute of Economic and Social Research.

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    More about this item

    Keywords

    cost channel; financial frictions; credit spreads; optimal monetary policy; fiscal policy; monetary union;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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