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The Stability Pact and Inefficiencies in Fiscal Policy Making in EMU

Author: KARI E.O. ALHO
Published in PFM, Vol. 1 No. 1

The aim of the paper is to analyse the Stability and Growth Pact of
EMU in a two-country model of monetary union with rational expectations
and with spillovers of macroeconomic policies between the countries. The
paper concentrates on tax policy, and shows that the results on optimal
policy crucially depend on whether the demand channel of taxes through
aggregate demand, or the supply channel, from taxes through wage
formation, dominates in the determination of the rate of inflation and the
international spillovers of policy. An optimal stability pact, which corrects
the inefficiencies in policy making considered here, i.e., the lack of fiscal
policy coordination between the countries and that between fiscal and
monetary policies, and political myopia, is derived. Finally, an evaluation
of the deterrent power of the existing Stability Pact with respect to deficit
spending is derived and found to be quite small in comparison to the shortrun
gains related to risking the sanctions of the Pact.

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