Fiscal Reform and Monetary Union in West Africa

changes in a monetary union arise from preference aggregation. Here, structural policy
changes are important and therefore only structural differences across economies are
allowed. This, of course, abstracts from many effects that have been discussed in the
literature, focusing on differences in preferences in the creation of fixed exchange rates and
monetary unions (see e.g. Berger et al. 2001).

2.2. The Situation before Monetary Union

As a benchmark, I begin with the situation before monetary union where countries have
monetary autonomy. Assuming that exchange rates follow purchasing power parity ensures
that exchange rate movements have no influence on output, and that the rate of inflation is
determined by domestic monetary policy only.

The game structure used is Stackelberg where the fiscal authority is the Stackelberg
leader; the solution concept is subgame-perfect equilibrium. The time structure is as
follows: (i) the government decides about the structural reform package s_i implying a
certain fiscal policy package x_i , (ii) having observed this, the private sector forms
expectations about the rate of inflation π_i^e, (iii) the central bank sets the rate of inflation π_i ,
and (iv) output is determined. The model is solved by backward induction.

Since the government is Stackelberg leader it takes the reaction of the central bank
into account when making its policy choices. The central bank's best response is

which, with rational expectations, becomes

(6)

<<   9   10   11   12   13   14   15   >>

More intriguing information