5. Monetary Union Among Asymmetric Countries
The reaction function of the central bank, obviously, would still be given as in (11). But the
policy choices of government i would take into account how the central bank reacts to the
other countries which are structurally different from the own economy.
The structural reforms and fiscal policy are respectively
A cω3 [F + b (y* - yj]
(22)
(23)
ʒi — л 9 9
λν22 + c2ω3
ɪ У n (xA +(y * - y,))(dθB - b θG- )
n j —1 j j j n
- c-------------------„2.2-----------------------
λν22 + c2ω3
and
AA _ FiλθBν2 - (y* - У) ^fλn^ν2 + c2ω3 )
xi — „2.2
λν22 + c2ω3
n En—,(χM'+(y*- yλ+c2 θG )
λν 22 + c 2ω3
where the superscript A denotes the case of an asymmetric monetary union. Thus, again the
fiscal policy becomes more distortive if the need for paying off debt is high, and it falls in
the difference between target and given output. Now, however, there is a different spillover
from country j's fiscal policy than before. The more distortive the fiscal policy of country j
the less so the fiscal policy of i will be. This is obviously due to the fact that such a policy
leads to higher inflation which government i aims to avoid. Given that country j's output
gap will also increase the rate of inflation of the common central bank, country i will
discipline its fiscal policy to avoid too high an increase in inflation. The stronger the
inflationary response of the common central bank is to the developments in all other
economies, the more i will avoid to put further pressure on the bank by running a less
distortive fiscal policy.
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