Optimal Fiscal Policy Rules in a Monetary Union

Abstract

This paper investigates the importance of fiscal policy in providing macroeconomic stabilization in a monetary union. We use a microfounded New Keynesian model of a monetary union, which incorporates persistence in inflation and non‐Ricardian consumers, and derive optimal simple rules for fiscal authorities. We find that fiscal policy can play an important role in reacting to inflation, output, and the terms of trade, but that not much is lost if national fiscal policy is restricted to react, on the one hand, to national differences in inflation and, on the other hand, to either national differences in output or changes in the terms of trade. However, welfare is reduced if national fiscal policy responds only to output, ignoring inflation.