Modern Economy, 2012, 3, 742-751 Published Online October 2012 (
Discretionary Fiscal Policy and the European
Monetary Union
Jason Jones
Department of Economics, Furman University, Greenville, USA
Received August 10, 2012; revised September 17, 2012; accepted September 26, 2012
A model of circumstances that can lead to changes in the way a fiscal authority conducts policy after joining a monetary
union is presented and empirically tested for the euro area. According to the model consolidation fatigue, shock asym-
metry, or differences in the relative weight placed on output/price stabilization between the new and old monetary au-
thority can lead to greater reliance on fiscal policy. Empirical evidence suggests that there has been a change in the
conduct of fiscal policy in the euro area which is most likely due to consolidation fatigue and a stronger emphasis on
price stabilization by the European Central Bank.
Keywords: Fiscal Policy; Policy Interaction; EMU
1. Introduction
The sovereign debt crisis among members of the Euro-
pean Monetary Union (EMU) underscores the need to
study fiscal policy in the currency union. In the years
immediately preceding the formation of the monetary
union the budgetary position of most members improved.
Soon after the formation of the monetary union, however,
budgetary positions began to deteriorate. The deteriora-
tion of fiscal positions in relatively good times made the
deficit effects of the global recession in the late 2000s
severe, leading to debt crises and bailouts of some of the
member states.
The change in fiscal balances soon after the creation of
the EMU suggests that part of the explanation could be
tied to the monetary union itself. Understanding how the
monetary union has modified the role and preferences of
its policymakers can help the union address its deficit
challenges. This understanding can also inform states
looking to join the EMU, as well as other monetary un-
ions under consideration around the world, of the possi-
ble fiscal challenges they may face.
This paper models and tests possible changes to dis-
cretionary fiscal policy as a result of becoming a member
of the EMU. By expanding Uhlig’s [1] model of policy
interaction and applying it both before and after the for-
mation of the monetary union, the fiscal challenges of
surrendering independent monetary policy are illustrated.
Specifically, increased reliance on scal management is
needed if shocks are dissimilar across members of the
monetary union or the policy weights of the new mone-
tary authority are different than the former local mone-
tary authority. The model also allows for an exogenous
change in the preferences of fiscal authorities to account
for consolidation fatigue identified by Hughes-Hallett
and Lewis [2].
To test this model and understand how discretionary
fiscal policy has changed in the euro area, a fiscal reac-
tion function is estimated allowing for a break at the
formation of the monetary union in 1999. Unlike most
fiscal reaction function literature, the response to supply
and demand shocks rather than the output gap is esti-
mated. The results suggest that there has been a change
in the way fiscal authorities respond to supply shocks
since becoming members of the EMU. The response be-
comes counter-cyclical after the formation of the union
and is most likely due to a stronger weight by the Euro-
pean Central Bank (ECB) on price stabilization relative
to output stabilization compared to the former local
monetary authority. Counter-cyclical fiscal responses
after the formation of the union could help explain the
worsening of budgetary balances. In addition, the fiscal
response to debt levels is weaker after the formation of
the EMU. This result suggests a role for consolidation fa-
tigue in explaining worsening deficit positions.
The remainder of the paper is structured as follows. In
the next section a model of monetary and scal policy is
constructed that explores the possible reasons for chan-
ges in the conduct of discretionary fiscal policy as a re-
sult of joining a monetary union. The following two sec-
tions introduce the empirical techniques and data used to
test how fiscal reactions have changed since the forma-
opyright © 2012 SciRes. ME
J. JONES 743
tion of the EMU. The final two sections present the re-
sults and conclude.
2. Theoretical Model
Modeling policy actions in a monetary union can be done
in a number of ways. One strand of research models
monetary and fiscal interaction in a monetary union us-
ing sophisticated micro-founded new-Keynesian general
equilibrium models (Benigno [3]; Beetsma and Jensen
[4]; Gali and Monacelli [5]; and Michalak, Engwerda,
and Plasmans [6]). These models explore welfare effects
of optimal and rule based policy with or without policy
coordination. These models, however, do not highlight
the changes in policy that come as a result of joining the
union. In addition, the complexity of these models re-
quires solution methods that mask the salient conditions
which could change fiscal management as a result of
joining a monetary union.
An alternate and tractable approach to study monetary
and fiscal policy in a monetary union focuses on the
strategic interaction between the policymakers without
the mico-foundations of a macroeconomic model. Dixit
and Lambertini [7] model the interaction between a cen-
tral monetary authority and different independent fiscal
authorities to look at what happens if they have different
output and inflation targets. Using a similar model, Dixit
and Lambertini [8] find that if the monetary and fiscal
authorities can agree on the ideal levels of output and
inflation, they can disagree about weights and still achi-
eve a first best solution. Beetsma, Debrun, and Klaassen
[9] present of model of strategic interaction to explore
fiscal coordination. They find that the benefits of coor-
dination depend on the type and symmetry of shocks that
affect the union.
A few authors have integrated strategic interactions in
the spirit of Dixit and Lambertini [7,8] with static mi-
cro-founded model in the spirit of the more complex
models of Beetsma and Jensen [4] to provide meaningful,
tractable models of policy in a monetary union. Uhlig [1]
is one of the first to use this approach to illustrate the
dangers of coordination failure in the EMU. Van Aarle,
Garretsen, and Huart [10] use a similar model to simulate
how different weights in fiscal policy functions can cause
nominal divergence. Using similar techniques, Bofinger
and Mayer [11] illustrate how shock asymmetry across
the union complicates stabilization policy within a union.
In order to illustrate these changes in a relatively sim-
ple, comprehensive, and informative manner a static mi-
cro-based strategic interaction model similar to [1,11] is
used. Unlike [1,11], this model explicitly represents the
interaction between policy makers before and after the
formation of the union to highlight the possible changes
in the conduct of fiscal policy. The model captures the
coordination challenges that arise if the shock is an infla-
tion shock relative to an output or demand shock [6]. It
highlights the importance of different weights on stabili-
zation priorities [10], as well as the role of asymmetry
[11]. The model also presents a role for consolidation
fatigue [2].
A typical model with Calvo sticky prices, no capital,
and a role for government is used. Following the mi-
cro-foundations of such models, the household’s optimi-
zation conditions, the firm’s optimization decision, and
the market clearing conditions are represented. In order
to provide a tractable solution and clear illustration of the
changes in how scal and monetary authorities interact
before and after the formation of the monetary union, a
nondynamic version of the model is used. Using these
conditions the log-linearized demand and Phillips curves
for each country (i) can be represented by
yai bg
In these equations, y is the output gap, i is the nominal
interest rate, π is ination, πe is expected ination, ν is a
demand shock (excluding fiscal shocks), and µ is a sup-
ply shock (where a positive shock is inationary; consis-
tent with a negative supply shock or a cost-push shock).
g represents discretionary fiscal policy. An upward mo-
vement in g (expansionary policy) causes an increase in
output and a worsening of budgetary positions due to
either spending increases or tax cuts.
The monetary authority cares about limiting ination
and output gap fluctuations. The monetary authority
chooses the nominal interest rate to maximize
ii i
, (3)
where θj is the relative weight the monetary authority
places on output gap verses ination stabilization.1 The
domestic monetary authority responds to the country
specific levels of the output gap and inflation, while the
union’s monetary authority responds to aggregate levels
of the output gap and inflation.
In addition to smoothing output gap and inflation
fluctuations, the fiscal authority of each country also
wants to limit budgetary fluctuations. Thus the fiscal
authority of each country maximizes
iiii ii
, (4)
where θf is the relative weight the fiscal authority places
on output gap verses inflation stabilization and can be
different than the weight of the monetary authority. α is
1Before joining the monetary union, j = m represents the domestic
monetary authority. After the formation of the monetary union, j =
represents the new central monetary authority.
Copyright © 2012 SciRes. ME
the weight placed on budget stabilization, while ε is an
exogenous fiscal shock which moves the budget away
from the steady state level. A positive shock would allow
for a higher value of g (larger deficits or smaller sur-
pluses) in the optimal solution. This would entail changes
to the budget beyond optimal stabilization, including
politically motivated deficit spending that might result
from consolidation fatigue.
The timing of policy is important for how the mone-
tary and scal authority decide to conduct policy. First,
agents form ination expectations, which before any
shocks are realized is zero. After those expectations are
formed, shocks hit the economy. Once the shock is real-
ized, the monetary authority responds first. The scal
authority then responds taking into account the monetary
authority’s actions. The model is solved using backward
induction as the monetary authority takes into account
the scal authority’s optimal response when it makes its
policy decision. Beetsma and Bovenberg [12] argue that
the long adjustment lag by fiscal authorities relative to
the monetary authority justifies this ordering.
Before joining the monetary union, each country has
control over its own monetary and scal policy. There-
fore, each country (i) solves its own individual country
specific problem. Solving using backward induction the
scal authority maximizes its objective function (Equa-
tion (4)) subject to the demand curve (Equation (1)) and
the Phillips curve (Equation (2)), taking the nominal in-
terest rate as given. The optimal response becomes
abi bviiiii
 
, (5)
where iiii i
 
The domestic monetary authority takes into account
the optimal reaction of the scal authority and maximizes
its objective function (Equation (3)) with respect to the de-
mand curve (Equation (1)) and the Phillips curve (Equa-
tion (2)), as well as the optimal scal reaction (Equation
(5)). The optimal response of the monetary authority thus
ii ii
ii m
ii ii
iv a
i ii
 
. (6)
Using the optimal monetary reaction, the optimal scal
reaction function can be calculated by substituting Equa-
tion (6) into Equation (5):
ffm fm
iiiiii iiiii
ii ii
 
 
 
In response to a positive demand shock (ν) or expan-
sionary fiscal shock (ε) the monetary authority raises the
interest rate to lower inflation and bring output back to
its natural level. The scal authority, on the other hand,
does not need to respond to a demand shock. Theoreti-
cally, both discretionary monetary and fiscal policy tools
influence the demand curve. The monetary authority is
assumed to respond to shocks first, and thus in the face
of a demand shock the monetary authority uses its policy
to return the demand curve to its desired position. The
fiscal authority knows this will be the monetary author-
ity’s response and that this monetary action will be taken
before they can respond, so they do not respond them-
In the face of a supply shock (u) however, the policy
maker must choose between output gap stabilization and
inflation stabilization. As a result, supply shocks are
more complicated and the fiscal response depends on the
relative weight that the monetary and scal authority
place on output gap stabilization. If stabilization goals
are the same (θf = θm) the monetary authority raises in-
terest rates in response to a supply shock and there is no
fiscal response. The fiscal authority knows this is the
monetary authority’s optimal response, and with the
same stabilization goals there is no need to respond. If
their stabilization goals are different (θf θm), the mone-
tary authority adjusts its policy in anticipation of the fis-
cal response, and the fiscal authority acts to overcome
both the supply shock and the monetary response.
Once countries become members of the monetary un-
ion, their scal choices change as the monetary system
changes. The union’s central bank must react to econ-
omy-wide fluctuations. This introduces a mechanism for
each member’s shocks to have an indirect effect on the
economies of the other members. In order to model this,
the output gap and ination to which the union’s central
bank responds is a weighted aggregate of each individual
member’s output gap and ination:
i ii
. (9)
In these equations, Γ is an (
n × 1) vector of weights
corresponding to the relative economic size of the un-
ion’s members. The individual weights add up to one. y
and π are (n × 1) vectors of the output gap and ination
of each of the member states.
In solving the problem using backward induction, the
domestic scal authority, taking the interest rate as given,
makes the same decision as before. The only difference
is that the interest rate is not dictated by the domestic
monetary authority, but by the union’s monetary author-
ity. The scal optimization result thus becomes
Copyright © 2012 SciRes. ME
J. JONES 745
gab ibii
In this case, i* is the nominal interest rate dictated by
the union’s monetary authority. The subscript (i) on the
parameters has been dropped because it has been as-
sumed for clarity and illustrative purposes that each
country has the same parameters across the union.
The union’s monetary authority now takes into ac-
count the aggregate output gap and ination of the mem-
ber states, as well as the aggregate scal reaction, and
. (11)
The optimal monetary policy for the union’s monetary
authority thus becomes
 
 
 
. (12)
In this case, ν, µ, and ε are (n × 1) vectors of country
specific shocks. This reaction is similar to the domestic
monetary authority’s actions except the new monetary
authority reacts to weighted averages of the country spe-
cific shocks. In order to solve for the domestic optimal
fiscal policy once the union’s monetary authority has
acted, it is convenient to rewrite Equation (12) as
 
 
 
ii ii
 
. (13)
Here, is the vector of weights i
11n ()
excluding the weight of country (i). Similarly ν, µ, ε are
the vectors of shocks excluding country (i).
Plugging Equation (13) into Equation (10) gives the fol-
lowing optimal fiscal response:
 
 
 
 
22 22
fM f
  
 
 
 
 
 
, (14)
where If
shocks and weights are identical across the monetary
union, this expression is the same as the one country
 
A comparison of Equation (7), the scal authority’s
optimal reaction before the formation of the union, and
Equation (14), the optimal reaction after the formation of
the union, illustrates how the role of the domestic scal
authority could change after the formation of the mone-
tary union. The scal authority now must take into ac-
count how large its country is in relation to other mem-
bers as well as how similar country specific shocks are to
those in the rest of the union. They also must take into
account how the new monetary authority’s relative
weight on output stabilization may be different than that
of the previous domestic monetary authority.
Sufficient similarity in shocks and thus synchronized
business cycles was cited by Mundell [13] as a necessary
criterion for a group of countries to be an optimal cur-
rency area (OCA). The problem of not meeting this OCA
criterion for the scal authority can be seen by compare-
ing Equations (7) and (14). For example, before joining
the union the scal authority did not need to respond to
any demand shocks, yet after the formation of the union
the scal authority optimally responds to a demand shock
when the country specific shock is different than that of
the aggregate shock. Assume a member state experiences
a country specific negative demand shock (νi) while the
average demand shock for all members in that period
) is positive. The local scal authority must now
increase deficits (or reduce surpluses) in response to its
negative country specific demand shock:
 
. (15)
At the same time, they must increase spending to
overcome the monetary authority’s response to the un-
ion-wide positive demand shock:
Before monetary unification, the country specific fis-
cal authority did not need to react to its own demand
shock, nor was it concerned with the symmetry of that
shock (in relation to its neighbors). After joining the un-
ion, shock asymmetry would lead to an increased role for
the local fiscal authority.
Greater reliance on scal policy may also be necessary
if the monetary union’s central bank has a response func-
tion different than that of the country’s monetary author-
ity. For example, the union’s monetary authority’s pref-
erence for output stabilization could be less than that of
2For example
ii M
 
if all fiscal shocks are the same.
This relationship is true for each shock.
Copyright © 2012 SciRes. ME
the country’s prior monetary authority (θM < θm). This is
a distinct possibility for many countries in euro area with
weak domestic central banks. The ECB adopted the
German model of central banking (with a strong repute-
tion for fighting inflation) and a one pillar strategy of
monetary policy on inflation stabilization (Wyplosz [14]).
In order to maintain the same level of output stabilization
as before, a scal authority may have to act more aggres-
sively because of the weaker response of the central bank.
To illustrate, assume that the shocks that hit the economy
are the same so the optimal reaction for the scal author-
ity is illustrated by Equation (7). If the weight the mone-
tary authority placed on output stabilization changes, the
scal reaction changes as follows:
22 22
bb b
bb u
 
 
 
where 2
 
01 11txttbtdtt
In this case, even if there is a common cost push shock
across the union, the scal authority increases deficits or
reduces surpluses if the new monetary authority is plac-
ing less weight on output stabilization (θm falls). The case
is similar for demand and scal shocks if there is shock
It is also possible that the changes in the decit are not
structural at all, but that greater decits are a result of
changes in political will. In an attempt to meet the decit
criterion of the Maastricht Treaty, most countries had to
implement sometimes painful structural as well as tem-
porary changes to their budgets. For example, in the run
up to the formation of the monetary union Italy went
through major pension reform, raising the retirement age
and increasing individual contributions in an attempt to
cut down the budget decit. In addition, temporary ad-
justments were made that did not change the structure of
the decit but did bring it in line with the Maastricht cri-
teria. Italy used the sale of public assets to increase gov-
ernment revenue, delayed contract renegotiations, and
even imposed a temporary Eurotax. Such reforms and
one-off measures are hard to maintain especially when
the promised returns from joining the union have been
slow in coming. Member state populations and politi-
cians may tire from the scal constraints imposed on
After the formation of the union, the deficit restrictions
in the Maastricht treaty were extended under the Stability
and Growth Pact (SGP). Under the Maastricht criteria,
rule violation would keep a country out of the union.
Punishment for violating the SGP, on the other hand,
comes in the form of fines. These fines are imposed by
fellow members who have little incentive to strap their
already strapped neighbors with further financial obliga-
tions. In such a way, governments have less incentive to
meet the somewhat arbitrary decit rules, especially
when there are economic strains at home. Eichengreen
and Wyplosz [15] suggest that European governments
traditionally have a decit bias. If politicians become
tired of reform, run out of temporary measures, and see
the enforcement of the SGP as weak, then worsening
deficits would be expected. Such consolidation fatigue
has been identified by Hughes-Hallett and Lewis [2] as
an important reason for the worsening of deficit positions
after the formation of the monetary union in Europe. In
terms of the model, if all the fiscal authorities decided
(irrespective of output or price fluctuations) to have
higher deficits once they enter the union, fiscal balances
will change in a one to one fashion.
3. Testing the Nature of Responses
In order to test for possible changes in the conduct of
fiscal policy illustrated in the model, a fiscal reaction
function is estimated. A fairly standard approach to
measuring fiscal reaction functions exists in the literature
and consists of estimating versions of the following
EXbf u
. (18)
In this model, current fiscal policy (ft) is a function of
the expected value of a macroeconomic indicator (Et-1 Xt),
last period’s debt level (bt-1), and last period’s fiscal
stance (dt-1). Most studies of fiscal reaction functions use
both the cyclically adjusted primary budget balance to
measure discretionary fiscal policy and the noncyclically
adjusted primary budget balance to study automatic sta-
bilizers. The primary balance is used to remove any in-
fluence changes in the interest paid on existing debt may
have on the budgetary balance. The macroeconomic in-
dicator most often used is the output gap. To estimate the
expected value, most authors use an instrumental vari-
able approach. The debt to GDP ratio is used to capture
any fiscal authority’s motivation to stabilize debt levels.
The lag of the fiscal variable is included to account for
possible autocorrelation in the budget decision.
The estimation of fiscal reaction functions in the EMU
has received a fair amount of attention in the literature.
Most of these explore how deficit restrictions impact the
way fiscal authorities operate in the euro area. Gali and
Perotti [16] find a change in the conduct of discretionary
fiscal policy since the budgetary restrictions were intro-
duced in the Maastricht Treaty. Whereas discretionary
fiscal policy was procyclical before Maastricht they have
become more counter-cyclical since that time (specifi-
Copyright © 2012 SciRes. ME
J. JONES 747
cally they have become less procyclical). This result in-
dicates that the deficit restrictions have not prevented the
fiscal authorities from exercising discretionary fiscal
policy as was feared.
Wyplosz [14] finds support for [16] conclusions using
the same empirical strategy on updated data. Garciá, Ar-
royo, Minguez, and Uxó [17] estimate the fiscal rule for
each country in the euro area using seeming unrelated
regression and find that policy was most procyclical
pre-Maastricht, and though it was still procyclical post-
Maastricht it was not nearly as strong and for many
countries it became acyclical. Von Hagen [18], on the
other hand, using pooled data instead of panel data finds
that discretionary policy has remained strongly procycli-
cal since Maastricht. Balassone, Francese, and Zotteri
[19] find no change in the way fiscal policy is conducted
since the introduction of fiscal restrictions, but they do
find cyclical asymmetry; discretionary policy is counter-
cyclical when there is a negative output gap, but does not
respond at all to positive output gaps. Using more current
data, Candelon, Maysken, and Vermeulen [20] find that
contrary to [16], discretionary policy has remained
strongly procyclical since Maastricht.
Due to data restrictions and the emphasis on the deficit
restrictions, which change little after the actual formation
of the union, only [17] test for changes in fiscal reactions
after the formation of the union. They find little change
in the way fiscal authorities respond to the output gap
when compared to the Maastricht period. These results,
however, do not reflect the possible changes to policy
that can come as a result of joining the union because
they do not identify what types of shocks lead to changes
in the output gap. As the model introduced in the previ-
ous section predicts, the type of shock is important when
looking at fiscal reaction functions before and after join-
ing a monetary union.
Candelon et al. [20] attempt to account for the sources
of output gap fluctuations. They use the European Com-
mission’s Business and Consumer Survey. Question
eight of the Industry/Business Climate Indicator, asks
companies about the most important factor limiting their
production. Answers of demand or financial constraints
are categorized as demand shocks, while responses of
labor or equipment were categorized as supply shocks.
These responses are aggregated to the country level to
create a supply and demand variable for each country in
each time period. They find that deficits increase when
there are supply constraints on firms, but they decrease
when there are demand constraints. This strategy of iden-
tifying supply and demand shocks has limitations in
terms of our model. Labor or equipment limitations on
firm production could be the result of either a supply or a
demand shock to the economy as a whole.
Strawczynski and Zeira [21] estimate fiscal reaction
functions for twenty-two OECD countries using perma-
nent and transitory shocks in the place of the output gap.
To identify these shocks they use the Blanchard and
Quah [22] technique of long run-restrictions on a VAR.
The use of long-run restrictions in VARs has been used
by a number of authors to identify supply and demand
shocks in Europe (Bayoumi and Eichengreen [23]; Fidr-
muc and Korhonen [24]; and Babetski, Boone, and
Maurel [25]). In order to identify structural shocks from
a reduced form VAR, certain restrictions, derived from
economic theory, must be introduced. Long-run restric-
tions rely on theoretical differences in how variables re-
spond to shocks at different time horizons. The restric-
tions used to identify supply and demand shocks are
based on assumptions derived from simple Keynesian
predictions. Theory suggests that while demand shocks
influence prices in the long run, they have no long-run
effect on output. Supply shocks, on the other hand, do
have permanent effects on both output and prices. The
restriction of no demand effects on output in the long run
allows for identification using the Blanchard and Quah
These identified shocks more closely match the shocks
from the theoretical model presented in the previous sec-
tions and are used in the place of the output gap. As a
result, the following panel response function is estimated
to test the theoretical model and potential changes in fis-
cal policy:
,01, 2, 3, 4,
5,1 6,1 7,1,
itit ititit
ititit it
bb f
 
 
 
 
  . (19)
Here, f and b are respectively the fiscal stance and debt
level. Supply shocks (s) and demand shocks (d) replace
the output gap in Equation (18). Supply shocks, demand
shocks, and the debt are split to before (BE) and after
(AE) the formation of the EMU. In this way a simple
Wald test can be used to determine if there is a difference
in the way the fiscal authority reacts to these variables
after the formation of the union. The expected value of
the supply and demand shocks is not needed as, by defi-
nition, they should be surprises. The current value of the
supply and demand shocks is used because the data are
annual. At this frequency the authorities’ have enough
time to respond to shocks within the period.3
A panel fixed effects estimator as well as the Arellano
and Bond [26] two-stage GMM estimator are used to
estimate the fiscal reaction function. The Arellano and
Bond estimator is used to account for possible correlation
between the lagged dependent variable and the unob-
served panel-level effects, which would make the fixed
effects estimator in a dynamic panel model inconsistent.
3Robustness tests have been run which use the lag of supply and de-
mand shocks with very similar results.
Copyright © 2012 SciRes. ME
Robust standard errors are estimated to correct for possi-
ble heteroskedasticity.
4. Data
The data come from AMECO, the European Commission
Economic and Financial Affairs annual macro-economic
database and are recorded from 1978 to 2010. Eleven of
the original twelve members of the EMU are used in the
analysis.4 The inclusion of fiscal variables necessitates
the use of annual data. Quarterly fiscal variables for
Europe are not available until recently and do not provide
enough observations to measure fiscal reaction functions
pre-EMU. For the VAR used to estimate the supply and
demand shocks the growth rate of real GDP and the in-
flation rate according to the GDP deflator are used. Han-
nan-Quinn information criterion and Schwarz’s Bayesian
information criterion indicate an appropriate lag length of
one or two for most countries. Chari, Kehoe, and Mc-
Grattan [27] highlight that estimation using long-run re-
strictions is improved the longer the lag length so a lag
length of two is chosen. One way to test the validity of
the long-run restriction is to generate impulse response
functions. According to theory a favorable demand shock
should cause an initial increase in output and prices. A
favorable supply shock, on the other hand, should cause
output to increase and prices to fall. This was observed
for all of the countries in the sample with the exception
of Germany and Italy.
The dependent variable in the fiscal reaction function
(fi,t) is the cyclically adjusted general government pri-
mary balance as a percentage of potential GDP for coun-
try (i) at time period (t). The cyclically adjusted balance
is used to capture discretionary fiscal policy which is the
basis for the theoretical model. Using the primary bal-
ance excludes the effect that changing rates of interest
(which would be outside of the fiscal authorities’ discre-
tion) have on budgetary balances. It also excludes a fea-
ture of monetary and fiscal interaction not captured in the
model. The lag of the debt to GDP ratio of each country
is used for (bi,t – 1).
5. Results
The model is first estimated without allowing for chan-
ges in the fiscal reaction function as a result of becoming
a member of the EMU. Table 1 contains these estimated
Columns (1) and (2) are estimated over the whole
sample using the Arellano-Bond estimator and the fixed
effects estimator respectively. The results are fairly con-
sistent across these two specifications.5 The lagged cy-
Table 1. Estimated fiscal reaction (no EMU effect).
(1) (2)
Debt to GDP ratio (lag) 0.0222***
Budgetary balance (lag)
Note: Values in parenthesis are robust standard errors using Windmeijer [28]
for the Arellano and Bond estimator and using the Huber/White/sandwich
estimator for the fixed effects model. ***Significant at 1% significant level,
**Significant at 5% significance level, *Significant at 10% significance level.
clically adjusted primary balance is positive and signifi-
cant as expected. The fiscal authorities also respond sig-
nificantly to the debt to GDP ratio when conducting po-
licy. The positive coefficient indicates that if there is a
high debt to GDP ratio last period, deficits are reduced or
surpluses are increased this period. This is consistent
with the literature which introduces the debt ratio into the
fiscal reaction function [16].6
The coefficients of most interest are those on the sup-
ply and demand shocks. A positive coefficient for a sup-
ply shock indicates that as output increases and prices
decrease as a result of the shock, the fiscal authority re-
duces deficits or increases surpluses which is counter-
cyclical to output. A negative sign would indicate pro-
cyclical policy in response to supply shocks. Similarly a
positive sign on the demand shock coefficient means that
as output and prices increase in response to a demand
shock deficits are reduced or surpluses are increased,
which again is counter-cyclical policy. Neither supply
shocks nor demand shocks are significant in the sample
as a whole.
Our theory, however, indicates that there could possi-
bly be a change in the way discretionary fiscal policy is
conducted after the formation of the union in 1999. To
test this theory we estimate Equation (19). The results are
presented in Table 2. The Wald tests for differences in
particular variables before and after the formation of the
union are presented in Table 3.
The reaction to the debt to GDP ratio remains positive
and significant before and after the formation of the un-
ion. There is a significant difference, however, between
the magnitudes of the response. Before the formation of
the EMU, the response to debt levels is statistically sig-
nificantly stronger than it is after the formation of the
union. This is consistent with the consolidation fatigue
identified by [2]. As the enforcement mechanism on
6Gali and Perotti [16] use deficits as their dependent variable, whereas
the budgetary balance is used here. As a result, a positive coefficient
here has the same interpretation as their negative coefficient.
4Luxembourg is excluded due to data limitations.
5The results are not sensitive to the inclusion of Germany and Italy.
Results are available on request.
Copyright © 2012 SciRes. ME
J. JONES 749
Table 2. Estimated fiscal reaction (with EMU effect).
(1) (2)
Debt to GDP ratioBE (lag)
Debt to GDP ratioAE (lag)
Budgetary balance (lag) 0.9102***
Note: Values in parenthesis are robust standard errors using Windmeijer [28]
for the Arellano and Bond estimator and using the Huber/White/sandwich
estimator for the fixed effects model. ***Significant at 1% significant level,
**Significant at 5% significance level, *Significant at 10% significance level.
Table 3. Wald test-difference in estimated coefficients.
(1) (2)
SupplyBE = SupplyAE
DemandBE = DemandAE
Note: Values in parenthesis are the associate p-value; *** Significant at 1%
significant level, ** Significant at 5% significance level, * Significant at 10%
significance level.
deficit and debt restrictions weakened in the move from
the Maastricht Treaty to the SGP governments became
lax in meeting the criteria. This particular change in fis-
cal policy can be accounted for by the epsilon in the
theoretical model as it reflects a political decision outside
of the desire to stabilize output and price fluctuation.
As the theoretical model predicted, the fiscal response
to demand shocks is insignificant before the formation of
the monetary union. The model does, however, allow
there to be more active fiscal responses to demand
shocks after the formation of the union if local demand
shocks are sufficiently different than those of the rest of
the union. These results however indicate that there is
still no significant response to demand shocks after the
formation of the union and that this response is no dif-
ferent than before the formation of the union. This sug-
gests that demand shocks are sufficiently similar across
the union as to not necessitate active fiscal policy.
The results in Tables 2 and 3 suggest that there has
been a change in the way fiscal authorities respond to
supply shocks. There is no significant response to supply
shocks before the formation of the union. This is consis-
tent with the theoretical model if the weight monetary
and fiscal authority place on output stabilization relative
to price stabilization is similar. After the formation of the
union, the fiscal authority begins to react to supply
shocks in a counter-cyclical manner. This change in fis-
cal behavior is consistent with the model’s prediction if
supply shocks are sufficiently different across member
states or if the relative weight the ECB places on output
and price stabilization are significantly different than the
original domestic monetary authority.
There have been a number of studies that look at busi-
ness cycles synchronization and shock similarity in the
euro area. De Haan, Inklaar and Jong-a-Pin [29] summa-
rize the vast literature and conclude that the euro area has
gone through periods of both convergence and diver-
gence. Most studies, however, agree that euro area busi-
ness cycles have become more synchronized since 1991.
There are a number of studies that look specifically at
supply and demand shock similarities in the euro area.
These studies find that supply shocks across Europe are
more correlated than demand shocks. Since supply
shocks are more correlated than demand shocks and our
results suggest that the asymmetry in demand shocks is
not large enough to cause changes in fiscal policy, it is
unlikely that asymmetry is the cause of the detected
In addition, recent evidence suggests that asymmetry
should become less of a concern as Europe becomes
more integrated. Clark and Wincoop [30] find the greater
economic integration in Europe has led to greater syn-
chronization of business cycles. This relationship in gen-
eral has been identified by a number of other authors as
well (most are based off of Frankel and Rose [31]). Their
results suggests that shock asymmetry and idiosyncratic
business cycles do not explain a greater need to rely on
scal policy, and as countries become more integrated
this concern should become less important.
Therefore, the change is most likely due to changes in
the weight the ECB is placing on output relative to price
stabilization when compared to the original monetary
authority. Fiscal policy after the formation of the union
has become clearly counter-cyclical. This indicates that
the ECB is placing greater relative weight on price stabi-
lization than the previous local monetary authority. In
order to maintain the same level of output stabilization
obtained before the formation of the union, they now
actively conduct counter-cyclical fiscal policy. The evi-
dence of a change in the stabilization preferences in the
central banks is consistent with the adoption of the Ger-
man model to central banking and the one pillar strategy
of monetary policy on inflation stabilization. This disci-
pline and credibility was lacking for many members of
the EMU with their own monetary authority.
Copyright © 2012 SciRes. ME
6. Conclusions
After the formation of the monetary union in 1999, fiscal
balances began to deteriorate. The deterioration of the
fiscal balances in relatively good times made the deficit
problems of the global recession in the late 2000s severe,
leading to debt crises and bailouts for some of the mem-
ber states. The timing of the reversal in budgetary bal-
ances suggests that the formation of the monetary union
played a role in the observed changes to fiscal policy.
Much of the literature suggest consolidation fatigue, as a
result of the stringent and enforceable deficit requirement
of the Maastricht treaty coupled with the weak enforce-
ability of the deficit restrictions under the SGP after the
formation of the union, caused the reversal. This paper
does find support for the consolidation fatigue hypothesis,
but it also explores how changes to the conduct of fiscal
policy could be a byproduct of joining a monetary union
in general.
A model of monetary and fiscal policy interaction be-
fore and after the formation of a monetary union illus-
trates how greater reliance on discretionary fiscal policy
is required if country specific shocks are asymmetric to
those of the rest of the union or if the weight the union’s
monetary authority places on price stabilization relative
to output stabilization is different than that of the pre-
monetary union local monetary authority. The model is
empirically tested for the euro area using a fiscal reaction
function that allows for a break at the formation of the
The empirical results match model predictions and
identify which features of the monetary union have in-
fluenced fiscal policy. Since the formation of the union,
individual member states have conducted counter-cycli-
cal fiscal policy in response to supply shocks. There was
no significant response to supply shocks in the run up to
the formation of the union. This result, coupled with the
fact that there is no detectable response to demand
shocks before or after the formation of the union, sug-
gests that the ECB’s relative weight on price stabilization
is greater than that of the monetary authorities in the in-
dividual countries before the formation of the EMU.
Member states trying to maintain the same level of out-
put stabilization as they had before the formation of the
union must use fiscal policy more than they did when
they had their own monetary authority with which they
had a more similar weight on output/price stabilization.
This increased reliance on fiscal stabilization policy, in
addition to consolidation fatigue, contributed to the
change in fiscal stances observed after the formation of
the EMU.
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