Main point (aim) of the paper
The EMU as a monetary union has benefits but the biggest
cost is that countries cannot use their monetary policy
anymore; which is now governed by the ECB exchange
rate adjustments impossible.
Should be no problem if labor mobility is high.
Unfortunately, labor mobility is quite low and investors also
remain focused locally.
Alternatives focus on centralization of tax-transfer systems
and cross-border fiscal transfers also rather unlikely.
Most likely solution: Fiscal policy.
How can fiscal policy stabilize country-specific economic
disturbances in the EMU?
Two-country model with direct spillovers stemming
from trade linkages and real-exchange rate
Consider best responses of countries using game theory:
Nash equilibrium and Stackelberg model (first-
Fiscal coordination efforts not based on a strong pre-
commitment capacity of the fiscal authorities (Nash
coordination) are likely to be counterproductive.
Fiscal coordination is most likely to be desirable when
the European economy is hit by asymmetric (demand
or supply) disturbances.
This is contrary to current research which shows that
fiscal coordination is required in cases of large
Centralized fiscal policy: Solution
We can use the basic conclusions from this paper in
creating a rationale for the use of fiscal policy, but we
need to be careful in accepting all of its conclusions.
Authors have built a model which can have
assumptions that are faulty and thus predict wrongly.
However, it does give an insight in the commitment
governance systems must show in order to let fiscal
policy work well.
Understanding the paper
How do the authors combine the two-period model to
game theory and consequently find the Nash
coordination and Stackelberg equilibrium? (theoretical
Remarks from NB
Page 4: “This is especially the case when shocks are
highly correlated between countries. Ironically thus,
fiscal coordination is most likely to be undesirable
when a set of countries form an optimum currency
Comment: This seems to be a contradiction. One aspect
of the OCA-theory is implementing a fiscal transfer
system among member states to make up for the loss of
monetary policy autonomy.