The Stability Pact and the Interdependence of Monetary and Fiscal Policy Rules

Abstract

Monetary union in Europe has ushered in a new economic regime in which monetary and fiscal policies are treated separately, and will be treated separately. This follows from the decision to create a completely independent Central Bank to run monetary policy for the whole European Area. That was a deliberate choice, and was always intended to be the key feature of Europe’s monetary regime. But if monetary policy is to be run independently of any of the national governments, then fiscal policies — which remain almost entirely in the hands of those national governments — will, by the same token, also become independent of monetary policy. That makes the issue of the rules by which monetary policies are chosen, and the extent to which they interact with fiscal policy (or vice versa), of crucial importance. Monetary and fiscal policies may be chosen and operated independently, but they will jointly determine the outcomes for each economy nevertheless.

The authors would like to thank the Leverhulme Trust for financial support (under Grant No. F,/273/W) while their research was being done.