Creator: Chari, V. V. and Kehoe, Patrick J. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 308 Abstract:
We analyze the setting of monetary and nonmonetary policies in monetary unions. We show that in these unions a time inconsistency problem in monetary policy leads to a novel type of free-rider problem in the setting of nonmonetary policies, such as labor market policy, fiscal policy, and bank regulation. The free-rider problem leads the union’s members to pursue lax nonmonetary policies that induce the monetary authority to generate high inflation. The free-rider problem can be mitigated by imposing constraints on the nonmonetary policies, like unionwide rules on labor market policy, debt constraints on members’ fiscal policy, and unionwide regulation of banks. When there is no time inconsistency problem, there is no free-rider problem, and constraints on nonmonetary policies are unnecessary and possibly harmful.
Keyword: Fixed exchange rates, European Union, Maastricht Treaty, Monetary regime, and Dollarization Subject (JEL): F30 - International Finance: General, E63 - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy, E58 - Central Banks and Their Policies, E42 - Monetary Systems; Standards; Regimes; Government and the Monetary System; Payment Systems, F41 - Open Economy Macroeconomics, F33 - International Monetary Arrangements and Institutions, F42 - International Policy Coordination and Transmission, and E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination