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Fiscal policy and inflation in a monetary union

José-Miguel Cardoso-Costa and Vivien Lewis ()

No 511922, Working Papers of Department of Economics, Leuven from KU Leuven, Faculty of Economics and Business (FEB), Department of Economics, Leuven

Abstract: This paper studies optimal fiscal policies in a small open economy within a monetary union. The government has access to nominal non-state contingent debt and distortionary labour taxes to finance exogenous spending. Price levels differ across countries due to consumption home bias; thus fiscal policy influences inflation and the terms of trade. Prices are flexible. We show that, unlike in a country with an independent monetary policy, some variability in labour taxes is optimal. This is true even when the terms-of-trade externality is shut down. While fiscal policy aims at smoothing production distortions, with nominal public debt there is an incentive to use taxes to inflate in bad times when debt levels are high, reminiscent of Chari et al's (1991) optimal monetary policy result.

Date: 2015-10
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Published in CES - Discussion paper series, DPS15.23 , pages 1-30

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Journal Article: Fiscal Policy and Inflation in a Monetary Union (2017) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:ete:ceswps:511922

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