Generalized Stability of Monetary Unions Under Regime Switching in Monetary and Fiscal Policies

• Published date: 01 February 2021
• DOI: http://doi.org/10.1111/jmcb.12699
• Author: BART HOBIJN,DENNIS BONAM
• Date: 01 February 2021

DOI: 10.1111/jmcb.12699

DENNIS BONAM

BART HOBIJN

Generalized Stability of Monetary Unions Under

Regime Switching in Monetary and Fiscal Policies

Earlier studies on the stability of monetary unions show that an ination-

targeting central bank imposes strict budgetary requirements on scal pol-

icy to obtain a unique stable equilibrium. Failure of only one scal authority

to meet these requirements already results in nonexistence of equilibrium.

Nevertheless, it might proveuseful to temporarily depart from such require-

ments in order to absorb country-specic shocks. We show that such de-

partures are feasible if scal authorities commit to switch to more sustain-

able scal regimes in the future. Debt devaluation and scal bailouts may

also broaden the range of policy stances under which monetary unions are

stable.

JEL codes: E62, E63

Keywords: Markov switching, monetary union, equilibrium stability and

uniqueness, monetary–scal interactions

M     periods in which

monetary and scal policymakers pursue a combined set of policies that, if they

were permanent, theoretical macro-economic models predict would result in an un-

stable macro-economic equilibrium . For example, Bianchi and Ilut (2017) provide

evidence that the failed disinationary attempts of the 1970s and early 1980s were

partly due to a combination of periods of active scal and active monetary policy in

the United States. This combination of policies is not sustainable, in that it leads to an

We would like to thank Jean Barthélemy and seminar participants at the Dutch Central Bank and the

European Central Bank, the 2017 and 2018 Computing in Economics and Finance conference, the 20th

Central Bank Macroeconomic Modelling Workshop, and the 5th Research Conference on “Macroeco-

nomic Policies, Output Fluctuations, and Long-Term Growth”for helpful comments and suggestions. All

errors are our own.

D B is with Econometrics and Modelling Department, De Nederlandsche Bank (E-mail:

d.a.r.bonam@dnb.nl). B H is with Arizona State University (E-mail: bhobijn@asu.edu).

Received July 18, 2018; and accepted in revised form November 12, 2019.

Journal of Money, Credit and Banking, Vol. 53, No. 1 (February 2021)

© 2020 The Ohio State University

74 :MONEY,CREDIT AND BANKING

unstable equilibrium in theoretical models in the long run if permanent. Of course,

these policy stances did not turn out to be permanent.1

Davig and Leeper (2007) point out that an economy could still have a determinate

stable rational expectations equilibrium even if it goes through prolonged periods of

policy combinations that either result in indeterminate or unstable equilibria if per-

manent. Whether the resulting equilibrium is determinate and stable depends on how

frequently the economy switches to other policy regimes and on the policy stances in

those regimes.2

In this paper, we consider how the stability conditions for a monetary union gen-

eralize when we allow for the presence of regime switching in monetary and scal

policies. The stability conditions in the absence of regime switches were analyzed by

Bergin (2000). He showed that the strict requirements on the joint properties of scal

and monetary policy for equilibrium stability and determinacy in a single economy

(Sargent and Wallace 1981, Leeper 1991) also apply in the context of a monetary

union. In particular, stability of a monetary union can be obtained only if all mem-

ber states, no matter their size, maintain a sufcient feedback between debt and taxes

(provided the central bank actively targets ination). However, the case in which a

member state of a monetary union ignores (at least temporarily) the accumulation of

its debt is particularly interesting, given the strong reliance on expansionary scal

policy to ward-off adverse country-specic shocks. Yet, despite its empirical rele-

vance, current macro-economic theory has little to say about this regime as it results

in an unstable equilibrium in xed-regime models. This paper aims to ll this gap

by focusing on the feasibility of this regime in a regime-switching setup. Thus, in

many ways, this paper is to Bergin (2000) what Davig and Leeper (2007) is to the

Taylor Principle.

We use a simple general equilibrium model for a monetary union that consists of

two endowment economies to illustrate how the stability conditions for a monetary

union in Bergin (2000) generalize in the case of regime switching in monetary and s-

cal policies. This stylized framework with endowment economies allowsus to clearly

isolate the main mechanisms at play.3

Our point of departure is a monetary union that goes through periods in which the

common monetary policy aims to anchor ination expectations by actively target-

ing union-wide ination through appropriate adjustments in the nominal interest rate

while scal policy is conducted differently across the two countries. In one coun-

try, taxes respond endogenously to changes in government debt in such a way that

long-term debt sustainability is ensured. In contrast, taxes are kept constant in the

1. A large body of empirical work, especially focused on scal and monetary policy in the United

States, shows that policy stances vary over time (Bianchi , Gonzalez-Astudillo 2013, Chen, Leeper, and

Leith 2015, Bianchi and Ilut 2017, Chang and Kwak 2017, Aldama and Creel 2018).

2. Canzoneri, Cumby,and Diba (2001) apply a similar intuition to scal policy, and showthat a stable

equilibrium requires a combination of active monetary and passive scal policies to prevail sufciently

often, but not necessarily always. Expanding on that notion and using a standard New Keynesian model,

Ascari, Florio, and Gobbi (2017) show that regime-switching possibilities may broaden the set of scal

and monetary policies that deliver a stable and unique equilibrium.

3. Weshow how our results generalize to the case with production economies in the Online Appendix.