Compatibility Between Monetary and Fiscal Policy Under EMU 1. Campbell Leith* Simon Wren-Lewis** *University of Glasgow **University of Exeter

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1 Compaibiliy Beween Moneary and Fical Policy Under EMU Campbell Leih Simon Wren-Lewi Univeriy of Glagow Univeriy of Exeer Abrac: The poenial imporance of fical policy in influencing inflaion ha recenly been highlighed, following Woodford (995), under he heading of he Fical Theory of he Price Level (FTPL). Some auhor have uggeed ha hi heory provide a raionale for he Pac for Sabiliy and Growh a a neceary condiion for he ECB puruing a policy of price abiliy. In hi paper, we relax he aumpion underpinning he FTPL by developing a wo counry open economy model, where each counry ha overlapping generaion of non-ricardian conumer who upply labour o imperfecly compeiive firm which can only change heir price infrequenly. We examine he cae where he wo counrie have formed a moneary union, bu where he fical auhoriie remain independen. We how ha he fical repone required o enure abiliy of he real deb ock i greaer when conumer are no infiniely lived. In principle, hi allow for ome compenaing behaviour beween governmen, bu we how ha he cope for compenaion i mall The moneary auhoriy can abandon i acive argeing of inflaion o abilie he deb of a mo one fical auhoriy, and any oher combinaion of policie will eiher reul in price level indeerminacy and/or indefinie ranfer of wealh beween he wo economie. Finally, in a erie of imulaion we how ha fical hock have limied impac on oupu and inflaion provided he fical auhoriie mee he (weak) requiremen of fical olvency. However, when moneary policy i forced o abandon i acive argeing of inflaion, hen fical hock have a much greaer impac on boh oupu and inflaion. JEL Code:E0, E63. Key Word: EMU, Sabiliy and Growh Pac, Moneary Policy, Fical Policy, Fical Theory of he Price Level Addre for correpondence: C. B. Leih, Deparmen of Economic, Univeriy of Glagow, Adam Smih Building, Glagow G2 8RT C.B.Leih@occi.gla.ac.uk We would like o hank Mahew Canzoneri, Julia Darby, Behzad Diba, Michael Woodford and paricipan a eminar a he Univeriie of Cambridge, Warwick and Srahclyde for helpful commen on an earlier draf of he paper. We are alo graeful o he ESRC (Gran No. L ) for financial uppor. All error remain our own.

2 Inroducion Following Woodford (995) a lieraure ha developed under he heading of he Fical Theory of he Price Level 2. Under cerain condiion 3 he economy i in one of wo regime - a Ricardian regime where he fical auhoriie ac prudenly, governmen deb doe no coniue an elemen of ne wealh and moneary policy i free o arge inflaion, and anoher, non- Ricardian regime, where fical inolvency require urprie inflaion o deflae he nominal value of governmen deb, irrepecive of he ance of moneary policy. In earlier work (Leih and Wren-Lewi (2000)) we relaxed a number of aumpion underlying he FTPL, by conidering a cloed economy wih overlapping generaion of conumer upplying labour o imperfecly compeiive firm which could only adju heir price infrequenly. Thi economy alo had wo able policy regime: one where he fical auhoriie abilied heir deb ock and moneary policy wa acive (uing he erminology of Leeper (99)), uch ha he auhoriie raied real inere rae when inflaion wa above arge, and anoher where fical inabiliy forced he moneary auhoriie o reac paively o inflaion by no raiing real inere rae. However boh moneary and fical policy affeced inflaion under boh regime, and, addiionally, boh regime could occur even if all governmen deb wa indexed. The FTPL ha alo been exended o he open economy in a number of paper 4. In Woodford (998) he exenion o he cae of a moneary union i raighforward in ha under he aumpion of he fical heory, wih he addiional implifying aumpion of inernaional rik haring, conidering wo counrie operaing under moneary union imply aggregae he budge conrain of he wo counrie ino a ingle conrain. Therefore, if one fical auhoriy make no aemp o adju fuure urplue o enure olvency hen anoher member ae can run ufficien urplue o compenae for hi in erm of he aggregae budge conrain. Eenially, he governmen of he pruden counry buy he deb of he profligae counry. When he aumpion of inernaional rik haring i dropped (a in Bergin(2000)), he concluion ha i i only he aggregae budge conrain ha deermine wheher we are in a Ricardian or non-ricardian 2 For a comprehenive urvey of he FTPL ee Chriiano and Fizgerald (2000) or Woodford (200). 3 The Fical Theory aume ha he real level of ax revenue and pending are exogenou uch ha he fical auhoriie do no adju real urplue o enure heir budge conrain i aified in he face of negaive fical hock (i.e. fical policy i acive in he ene of Leeper (99). I i alo aumed ha all real eigniorage revenue are repaid o conumer. The decripion of he economy i compleed wih he inroducion of an infiniely lived yeoman farmer and a a reul he ex ane real inere rae i idenical o he repreenaive agen rae of ime preference, and i unaffeced by moneary and fical policy. Under hee condiion, he governmen finance are inulaed from he effec of moneary policy and, when price are flexible, he price level adju o aify he governmen budge conrain. 4 Dupor (2000), Daniel (200) and Loyo (998) conider he fical heory in he conex of wo open economie operaing under flexible exchange rae, and eek o addre he queion a o wheher or no he FTPL can deliver a deerminae nominal exchange rae and price level in he wo economie. Woodford (998), Bergin (2000) and Sim (997) conider he cae of open economie which have enered ino a

3 regime (Woodford (998)) ill hold, bu he pruden governmen will be ranferring he wealh of i ciizen abroad and hereby reducing heir conumpion relaive o conumer in he profligae economy. Therefore, i i uggeed (ee for example, Sim (999)) ha if one member ae doe no ac o abilie he deb ock, hen i i unlikely ha oher member ae will ac o compenae hi behaviour, and we will find ourelve operaing in he world of he FTPL. In hi paper, ecion, develop a wo counry open economy model, where - unlike he FTPL 5 - each counry ha overlapping generaion of conumer who upply labour o imperfecly compeiive firm which can only change heir price infrequenly. Conumer in each counry purchae good produced boh a home and abroad. We examine he cae where he wo counrie have formed a moneary union, bu where he fical auhoriie remain independen. Canzoneri e al (200) conjecure ha exenion of hi kind may be crucial in deermining he plauibiliy of uainable non-ricardian regime in he real world. Our analyi confirm hi conjecure. Secion 2 analye he rericion on moneary and fical policy neceary o reach a unique addlepah-able raional expecaion oluion which doe no involve indefinie ranfer of wealh from he conumer of one economy o he conumer of he oher. Secion 3 hen calibrae he model and compare he macroeconomic conequence of a fical hock under he variou policy regime idenified in ecion 2. Secion 4 conclude..a Two-Counry Model under EMU. The Conumer Problem: A ypical home conumer, i, derive uiliy from conuming a bake of conumpion i good, c, from holding real money balance, M P i, and uffer diuiliy by providing labour ervice 6, i N, We aume ha conumer face a conan inananeou probabiliy of deah, k, and can pool he rik aociaed wih he variaion in labour upply ha arie from aggered price eing. Thi mean ha we can wrie he conumer cerainy equivalen uiliy funcion a, i i i M i EU = [ln( c) + χln( ) + κ ln( N)]exp( ( σ + k)( d ) () P moneary union wih a fixed nominal exchange rae and common moneary policy, bu which ill operae independen fical policie. 5 Woodford (998), alo relaxe he aumpion of flexible price, bu reain he aumpion of infiniely lived conumer. 6 Thi pecificaion i imilar in erm of funcional form o Obfeld and Rogoff (998), alhough we abandon he aumpion of infiniely lived conumer and allow conumer o upply labour o firm raher han ac a yeoman-farmer. 2

4 where i he individual rae of ime preference and he bake of conumpion good i defined by he following CES index applied acro home and foreign good, θ θ i i [ ( ) θ ] θ = (2) c c z 0 Similarly, he conumer price index i given by, θ P [ () ] pz θ = (3) 0 Since here are aumed o be no impedimen o rade, he law of one price hold for each individual good, o ha he home price index can be re-wrien a, n θ θ [ ( ) ( ()) ] = θ + ε (4) P p z dz p z dz 0 n where p(z) i he home currency price of good z, p(z) i he foreign currency price of good z and ε i he nominal exchange rae, which we can normalie o a fixed nominal value of under moneary union. The conumer can hold her financial wealh in he form of domeic governmen bond, D, foreign bond, F, and money balance, M. Due o inernaional arbirage, domeic and foreign bond earn he ame nominal reurn, R, while domeic conumer receive a hare in he profi of domeic firm, Π. I i aumed ha he conumer receive a premium from perfecly compeiive inurance companie in reurn for heir financial ae, including money, hould hey die. Thi effecively raie he rae of reurn from holding financial ae by k. Conumer pay lump um axaion of T. Therefore, he conumer budge conrain, in real erm, i given by, i i i i A e A M M W i Π T i d = ( r λπ ( π ) + k) + ( k π) + N + c P P P P P P P where A i repreen conumer i financial ae and r i he ex ane real inere rae. (5) The parameer λ meaure he proporion of deb which i nominal. Therefore, whenλ = 0 all inere-bearing financial wealh i fully indexed uch ha he ex po real inere rae enjoyed by holder of he financial ae i equivalen o he ex ane real inere rae. When λ = all inere-bearing financial wealh i nominal and urprie inflaion can erode he real value of financial wealh by decreaing he ex po real inere rae relaive o he ex ane rae a 3

5 under he Fical Theory. In our policy imulaion we hall aume ha he economy wa iniially in eady-ae before an unanicipaed hock move he economy away from hi eady-ae. We hall hen rack he repone of he economy o hi hock under differen decripion of moneary and fical policy. A a reul, when he hock hi he economy i i poible for ex ane real rae o differ from ex po real rae. However, for he remainder of he imulaion, due o he pooling of rik reuling from finie live and ochaic price eing, he economy behave a if i i operaing under perfec foreigh. Therefore, we can drop he diincion beween ex ane and ex po real rae in period oher han he iniial period,, in which he hock hi. The conumer hen ha o maximie uiliy () ubjec o her budge conrain (5) along wih he uual olvency condiion. The variou fir order condiion hi implie are a follow. Firly, here i he uual conumpion Euler equaion, i i dc = (() r σ ) c (6) Secondly, opimiaion yield a money demand equaion, M P i i c = χ (7) R Finally, he individual opimal labour upply deciion will aify, W ( N i ) i = cκ (8) P Inegraing he conumer Euler equaion forward and ubiuing ino he ineremporal budge conrain yield he fully olved ou verion of he conumpion funcion, i i A W i Π c = ( k + σ)( + ( N + τ )exp( ( r( µ ) + kd ) µ ) d P P P (9) If we normalie oal populaion ize o one, hen by noing ha he curren ize of a generaion of ize k when born a ime z i kexp( kz ( )), we can wrie aggregae conumpion a, i c = ck exp( ki ( )) di (0) 4

6 Applying hi aggregaion o all variable allow u o derive he aggregae domeic conumpion funcion a, A W Π c = ( k + σ)( + ( N + τ )exp( ( r( µ ) + kd ) µ ) d P P P () where he aggregae financial wealh of domeic conumer i made up of heir holding of money, domeic bond and foreign bond, A = M + D + F. The relaionhip beween aggregae per capia labour upply and he real wage i given a, W ( N ) = cκ (2) P while he money demand equaion i given by, M P c R = χ (3) In he foreign counry here will be correponding equaion for labour upply, money demand and conumpion. The Firm Problem: In he abence of capial and wihou any conrain on price eing he firm would imply maximie profi in each period in a aic manner. However, i i aumed ha firm are ubjec o he conrain implied by Calvo (983) conrac uch ha a each poin in ime firm are able o change price wih a probabiliy α. A firm canno adju heir price coninuouly, here i an ineremporal dimenion o he firm pricing/oupu deciion. Suppoe he firm i charging a price, pz ( ), a ime, hen he dicouned value of he expeced profi generaed over he expeced remaining life of he price conrac are given by, pz () W V = [ yz ( ) Nz ()](exp( ( r( µ ) + α ) dµ ) d P P (4) For impliciy i i aumed ha he firm producion echnology i linear, yz ( ) = N( z). The CES form of he uiliy funcion implie ha he ih conumer demand for produc z i given by, 5

7 θ () i i c cz pz () = P (5) Inegraing demand acro conumer and auming ha each governmen allocae i pending in he ame paern a conumer implie ha world demand for produc z i given by, θ pz () () = ( ) P yz c c g g (6) where y(z), c, c, g, and g are defined a real per capia variable. Given he linear producion funcion, he firm (per capia) demand for labour will be equivalen o equaion (6). Uiliing he home and foreign demand for produc z, allow u o rewrie he objecive funcion of a firm which i able o change price a ime a, θ p W p V = [ Y](exp( ( r( µ ) + α ) dµ ) d P P P (7) where p i he price choen by uch firm. given by, The opimal price implied by he maximiaion of hi objecive funcion i herefore p = θ θ W( c + g + c + g)exp( ( r( µ ) + α ) dµ ) d P θ ( θ ) ( )exp( ( ( µ ) α ) µ ) P + + c g c g r d d (8) The home oupu price index, p(h) i a weighed average of he price e in he pa, where he weigh reflec he probabiliy ha hee price are ill in exience, θ θ ( ) = [ α exp( α( )) ] ph p d (9) where p i he price e in accordance wih equaion (8) by hoe home producer ha were able o change price a ha poin in ime. The aggregae conumer price level i, in urn, given by, 6

8 θ θ [ ( ) ( ) ( ) ] θ P = np h + n p f (20) and average home oupu i given by, θ ph ( ) ( ) = ( ) P yh c g c g (2) which, given he linear producion echnology, mean ha demand for labour i obained by umming acro he n home firm, θ ph ( ) = ( ) P N n c g c g (22) The Governmen The home governmen budge conrain in real erm i given by, dl = ( r λπ ( π e ))( l m ) π m + g τ (23) where he oal liabiliie of he governmen, l comprie governmen bond held by home conumer, d, or by foreign conumer, f, and non-inere bearing money, m. The proporion of deb which i nominal i given by λ. Therefore, a urprie inflaion will erode he real value of governmen deb which i denominaed in nominal erm. Aide from borrowing and eigniorage, he governmen finance pending by levying a lump-um ax of τ on home conumer. Noe ha while our model allow for urprie inflaion eroding he real value of nominal deb a in he FTPL, our budge conrain allow for a number of addiional effec no preen in he FTPL. Firly, we do no aume ha eigniorage revenue are auomaically rediribued o conumer herefore he effec conained in he unpleaan moneari arihmeic of Sargen and Wallace (975) are poenially preen in our model. Secondly, by inroducing non-ricardian conumer and nominal ineria, boh moneary policy and fical policy can affec real inere rae and hereby, real deb ervice co. The foreign governmen budge conrain i given by, dl = ( r λπ ( π ))( l m ) π m + g τ (24) e 7

9 Since he nominal exchange rae i fixed and PPP hold in erm of conumer price, he real rae of inere payable on governmen deb, defined in erm of conumer price, i he ame in boh counrie. 2.Compaibiliy Beween Moneary and Fical Policy. The Seady-Sae and Log-Lineariaion In hi ecion we ae he abiliy of our wo moneary union economie. In order o do o we fir linearie our model around a ymmerical eady-ae. We alo aume, for impliciy, ha he rae of inflaion in our eady-ae i zero, o ha he mi-pricing due o overlapping conrac will no exi in eady-ae. Equaion (8) how ha he opimal price in eady-ae, which i he ame a ha which would be e under flexible price, i given by θ ph ( ) = W (25) θ Combining hi wih he labour upply condiion, he producion funcion and he naional accouning ideniy (in he ymmerical eady-ae he curren accoun will be in balance o ha y = c + g), yield he following equilibrium oupu, θ + κ g y = N = θ (26) θ + κ θ The eady-ae conumpion funcion become, c ( y τ ) D F M = ( k + σ ) r + k P P (27) he domeic governmen budge conrain become, and money demand i given by, D+ F P τ g = (28) r 8

10 c m = χ (29) r Noe ha in hi ymmerical equilibrium, wih PPP due o free rade, i will alo be he cae ha F he real value of deb held overea will be he ame in boh counrie, P F =. Thi fac, P combined wih equaion (26)-(29), will deermine he eady-ae value of real ae in he model, along wih he equilibrium real inere rae, which i given by, r = 2 2 ( y g) σ + ( y g)( σ ( y g) + 4( kk+ σ)( τ g) y g (30) Since conumer are no infiniely lived, he real inere rae i no idenical o conumer rae of ime preference, bu will be affeced by he ouanding ock of governmen liabiliie, ince hee liabiliie coniue conumer ne wealh. Appendix deail he log-lineariaion of he model around hi eady-ae, uch ha our wo-counry model can be decribed by he following equaion. Firly, he aggered price eing behaviour of our imperfecly compeiive firm generae an open economy verion of he New Keyneian Phillip curve, N αα ( + r) dπˆ h rπˆ h αα r cˆ yˆ yˆ yˆ N θ 2 2 ( ) = ( ) ( + )( + ) ( ) (3) In andard cloed-economy formulaion of he New Keyneian Phillip curve, curren exce inflaion i relaed o expeced fuure oupu gap a firm, which can only renegoiae price conrac a random inerval, raie price now in anicipaion of worker demanding higher wage o upply he labour required o produce higher oupu in he fuure. Our model reflec he ame baic mechanim, bu recognie ha worker deire o conume more include no only conumer good, bu alo leiure. Therefore, he wage increae required o ecure more labour o increae producion are greaer when ha producion goe o aify an increae in domeic conumpion, raher han increaed governmen purchae or foreign conumpion. Thee effec explain he differenial impac of domeic conumpion, domeic oupu and foreign oupu on oupu price inflaion. The correponding equaion for he foreign economy i given by, N αα ( + r) dπˆ( f ) = rπˆ( f ) αα ( + r)( cˆ + yˆ) ( yˆ yˆ) N θ 2 2 (32) 9

11 The demand curve derived from he CES uiliy funcion implie he following definiion of average home firm oupu, ˆ g g yˆ = θ ph ˆ( ) + θp + ( ( cˆ + cˆ ) + ( gˆ + gˆ )) (33) 2 y y and average foreign firm oupu, ˆ g g yˆ ˆ( ) ( ( ˆ ˆ ) ( ˆ ˆ = θ p f + θp + c + c + g + g )) (34) 2 y y The pah for conumpion in each economy follow he Euler equaion, which for he home counry i, τ g + χc dcˆ = ( r + k ( k + σ)( + χ)) cˆ + rrˆ kk ( + σ) aˆ (35) rc and for he foreign counry, τ g + χc dcˆ = ( r + k ( k + σ)( + χ)) cˆ + rrˆ kk ( + σ) aˆ (36) rc Thee are he uual conumpion Euler equaion, adjued for holding of money balance and allowing for he poibiliy ha finie live mean ha governmen deb coniue an elemen in ne wealh. Noe ha when k = 0, conumer live forever and he level of governmen deb ha no impac on conumpion. according o, Given hee opimal pah for conumpion, he privae ecor ae will evolve rc ry τ r daˆ ˆ ˆ ( ) ˆ ˆ ˆ = ra + rr + χ c + y τ τ g + χc τ g + χc τ g + χc (37) Again here i a correponding equaion for he foreign economy, rc ry τ r daˆ = raˆ + rrˆ ( + χ) cˆ + yˆ τˆ τ g + χc τ g + χc τ g + χc (38) 0

12 In hi open economy model, privae wealh in one counry i no ynonymou wih he level of public ecor liabiliie in ha counry. Any increae in he level of he financial wealh of he privae ecor relaive o he liabiliie of he governmen implie an increae in holding of foreign deb. In fac, he flow budge conrain of he home governmen i given by, χ cr τ r dl rl rr c c τ g + χc 2 2 τ g + χc ˆ ˆ = + ˆ ( ˆ + ˆ) τˆ (39) and for he foreign governmen, ˆ ˆ χ cr τ r dl = rl + rrˆ ( cˆ + cˆ ) τˆ τ g + χc 2 2 τ g + χc (40) There are alo wo global marke clearing condiion. Firly, for he good marke, g g yˆ ˆ ( ˆ ˆ ) ( ˆ ˆ + y = c + c + g + g ) (4) y y and, econdly, for he ae marke, aˆ + aˆ = lˆ + lˆ (42) All ha remain i o complee our decripion of moneary and fical policy. Decribing Policy: In decribing policy we aume ha he moneary and fical auhoriie implemen imple rule. Thi allow u o oba in racable reul depie he underlying complexiy of he model. I alo allow u o make clear comparion wih oher udie in he lieraure which have uilied hee imple rule (ee, for example, Leeper (99), Woodford (998) and Sim (997)). We aume ha he common moneary policy involve eing real inere rae o arge inflaion o ha, r = r + mπ, which implie m rˆ = ˆ r π (43)

13 Due o he equaliy of real rae acro he economie and he exience of PPP in conumer price, hi i conien wih a moneary policy which e European inere rae o arge Europe-wide conumer (or oupu) price inflaion. Now uppoe fical policy ac o abilie he liabiliie of each fical auhoriy independenly. We follow Sim (997) in formulaing a imple rule a follow, τ = φ + φ l (44) o Thi rule can be log-linearied a, in he home economy and, τ ˆ τ = φ g l ˆ (45) rτ τ τ g = l (46) rτ ˆ ˆ φ in he foreign economy. Neceary Condiion for Saddle -Pah Sabiliy: We now analye he neceary condiion for addle -pah abiliy in our model, in an aemp o dicover any enion/ineracion in he eing of moneary and fical policy wihin our wo-counry model. Before doing o i i helpful o dicu why analying policy configuraion which are conien wih raional expecaion equilibria wihou implying indefinie ranfer of wealh beween member ae i ueful. Some paper which aemp o apply he FTPL o EMU imply ak wheher or no he price level i deermined by moneary or fical policy (ee Woodford (998) for example) by examining wheher or no he aggregae budge conrain acro he moneary union place u in a Ricardian or non-ricardian regime. Oher auhor (ee for example Bergin (2000) or Sim (997)) noe ha by only looking a he aggregae budge conrain we may oberve policy configuraion where here are indefinie ranfer of wealh from he ciizen of one economy o he oher. For reaon of uainabiliy hee auhor would like o reric fical policy uch ha one auhoriy canno run a no-ponzi cheme again he oher. In he cae of he former, a muli-counry model of moneary union allow budge conrain o be aggregaed acro member ae uch ha he equilibria idenified in cloed economy applicaion of he FTPL will alo apply. However, if we wih o reric fical policy uch ha one member ae doe no indefiniely accumulae he deb of he oher, hen hi 2

14 will limi he e of feaible equilibria ince each counry ineremporal budge conrain generae an equilibrium condiion which mu be aified 7. In our model, i i no poible o a priori divide policy ino Ricardian or non- Ricardian regime ince a all poin in ime moneary and fical policy joinly deermine he value of real and nominal magniude in our economie. However, we mu make a deciion on wheher or no o permi one fical auhoriy o indefiniely accumulae he deb of anoher. If we were o conider hi behaviour, hen we oo would be able o aggregae equaion acro our wo economie in order o analye he exience of global raional expecaion equilibria. However, hi model of moneary union would, in eence, be equivalen o a cloed economy model of he or analyed in Leih and Wren-Lewi (2000) wih he ame rericion on moneary and fical policy being required o enure he exience of a addlepah-able raional-expecaion equilibrium. Therefore, in hi paper, we reric fical policy uch ha one auhoriy canno run a no-ponzi cheme on he oher. Accordingly, by analying he addlepah abiliy of he dynamic yem derived below, we can idenify he idenify he combinaion of moneary and fical policy which will deliver a unique pah for price under raional expecaion and which do no violae he addiional rericion on fical policy. To underake hi abiliy analyi i i helpful o repreen our economie a a dynamic yem in marix algebra form. Thi can be achieved quie eaily a follow. Fir of all, noe ha he global marke clearing condiion, allow u o eliminae one of our financial ae/liabiliy variable from he yem ince i i deermined a a reidual of he oher hree. We chooe o drop a, alhough he choice i immaerial 8. Similarly we can eliminae y from all equaion uing he ˆ condiion for marke clearing in he good marke. Finally, noing ha he definiion of conumer price implie ha P = ph ( ) + ( p( f)) 2 2 ˆ i can be een ha home firm oupu (33) depend upon aggregae demand and he real exchange rae, which can be defined a, eˆ = ph ˆ( ) pˆ( f). Therefore, any erm in domeic oupu can be replaced wih a combinaion of he real exchange rae and he componen of aggregae demand, cˆ, cˆ, g ˆ and g, alhough we alo need o add an equaion decribing he evoluion of he real exchange rae, ˆ 7 Wheher or no he fical auhoriie are rericed in he accumulaion of he deb of oher counrie i alo crucial in enuring deerminacy of he nominal exchange rae in flexible exchange rae regime. In he abence of any rericion, he wo budge conrain can be aggregaed ino a ingle conrain which i inufficien o deermine wo price level and he nominal exchange rae. While if fical policy i rericed, he wo budge conrain remain eparaed and he wo price level (and nominal exchange rae) are now fully deermined. (See Canzoneri e al (200) for a dicuion of hi poin). 8 In fac i i poible o repreen he dynamic yem in a number of way. For example, by differeniaing he equaion for oupu, we can replace he dynamic equaion for he real exchange rae wih a dynamic equaion for domeic oupu however he underlying dynamic yem are idenical and a a reul o are he abiliy condiion we derive below. 3

15 deˆ = πˆ( h) πˆ( f) (47) By adding he decripion of policy oulined above, we can repreen he wo economie in marix form a follow, 4

16 N N c N ca r 0 a( + θ) a( + ) N 2 Ny Ny2 N N ca N c 0 r a( + θ ) a( + ) N Ny 2 2 Ny dπˆ( h) πˆ( h) dπˆ( f) πˆ ( f ) deˆ m m eˆ 0 r + k v( + χ ) z dcˆ 2 2 cˆ dcˆ = m m cˆ 0 0 r + k v( + χ) z z z dlˆ 2 2 lˆ m m χrc χrc ˆ dl 0 r φ ˆ 0 0 l daˆ 2 2 x x m m χrc χrc aˆ 0 0 r φ x x m m rθy ( + χ) rc rc rc + φ 0 r 2 2 2x x 2x 2x τ g + χc where a= αα ( + r),v = k + σ and z = kk ( + σ ) and x= τ g + χc. rc 5

17 The conrain on policy required o enure a dynamically able economy are probably clearer, if we aume ha he economy approache i cahle limi 9 (a in Woodford (998)) i.e. χ 0. Thi ha he implicaion ha he cenral bank reain conrol over nominal inere rae, bu ha he conribuion of eigniorage revenue o governmen finance are negligible. Woodford (op. ci.) how ha hi cahle economy reain he eenial feaure of he FTPL and hi i confirmed for a cloed economy wih icky price and non-ricardian conumer in Leih and Wren-Lewi (2000). The deerminan of he raniion marix of our wo counry model i given by, ( ) () i ii 2 N g τ g φ φ τ 2 N g z( )( ) z 2 ( r ( r ) ram ( ) ) 2 + θ θ σ r N y τ τ r + + r y N y τ a g y τ g N g N g g y φ φ y N y N y τ r r 2 ( ) 3 ( ) r σ ( θ ) τ ( ) τ zam A neceary condiion for abiliy i ha he deerminan of hi marix be poiive, ince we require four eigenvalue wih negaive real par (correponding o he pre-deermined variable 0, e ˆ, a ˆ, l ˆ and l ˆ ) and four eigenvalue wih poiive real par relaing o he jump variable in he yem ( π ˆ ( h), π ˆ ( f ), c ˆ, and c ˆ ). The fir hing o noe i ha he expreion wihin he quare bracke labelled (i), i unambiguouly negaive and doe no conain any of he parameer wihin he policy rule. Therefore in aeing he deerminan condiion for abiliy we need only conider he expreion wihin he econd quare bracke, labelled (ii), which mu be negaive a a neceary condiion for addlepah abiliy. In hi conex addlepah abiliy implie ha all variable in he yem will reurn o he eady-ae following a emporary fical hock a noed above hi implie ha we are no allowing one governmen o run a no-ponzi cheme again he oher. If we were o allow hi hen we could imply aggregae he equaion 9 Even if we allowed for eigniorage revenue, for plauible value of χ he abiliy condiion hown here are no maerially affeced. Thee more complex condiion are available from he auhor upon reque. The numerical analyi ha follow hi ecion allow for non-zero value of χ. 0 I hould be noed ha he iniial value of real governmen liabiliie and privae ecor ae, may be influenced by any urprie inflaion if hey are denominaed in nominal erm. However, ince hey are no hemelve free o jump o any level o eliminae he influence of unable eigenvalue on he dynamic yem hey hould no be conidered o be jump variable. 6

18 acro he wo economie and reduce he yem o a cloed economy model of he ype analyed in Leih and Wren-Lewi (2000). Compaibiliy Beween Moneary and Fical Policy We can uilie hi abiliy condiion o conider how he moneary auhoriie may be conrained by variou combinaion of member ae fical policie. The brackeed expreion labelled (ii) i negaive when, φ φ 2 N g 2( r ( r σ ) + ram + ( )) r r N y N g φ φ < zam + ( ) + 2 N y r r (48) Thi inequaliy can be re-wrien condiional on variou policy parameer combinaion a he following wo e of inequaliie, and, z r( r σ ) + < 2 φ N g r φ r ma( + ( )) N y m > ( < )0 and ( φ r)( φ r) > ( < )0 z r( r σ ) + > 2 φ N g r φ r ma( + ( )) N y m > ( < )0 and ( φ r)( φ r) < ( > )0 (49) (50) The fir e of inequaliie, (49), capure he policy regime which are open economy verion of Leeper (99) definiion of acive and paive moneary/fical policy regime. The econd e of inequaliie reflec correcion o hee definiion which emerge in he preence of non-ricardian conumer. Thi i becaue (50) can only hold in he cae of non-ricardian conumer, ince a he probabiliy of deah end o zero, he parameer z end o zero and he real inere rae end o he rae of ime preference. To underand hee abiliy condiion more clearly i i helpful o repreen hem diagrammaically in Figure. To do o ubiue he expreion for he equilibrium real inere rae, equaion (30) ino (i) and N g τ g N z( + θ)( ) + ( r σ) ( + θ) zθ N y y N rearrange o give, N N ( k+ σ) k( τ g)[( θ( + ) + ) y τ ( + θ)] = 2 N N < 0 2 y[( y g) σ + ( y g)( σ ( y g) + 4 kk ( + σ)( τ g)] 7

19 Figure Compaibiliy Beween Moneary and Fical Policy φ r m < 0 m <Ψ m < 0 m > 0 φ r τ g N g kk ( + σ ) αα ( + r) m( + ( )) rc N y 2 N g r( r σ) αα ( r) m( ( )) N y m < 0 In Figure he x-axi meaure he value of φ r, while he y-axi meaure, φ r wo hyperbola race ou he combinaion of fical feedback parameer for which he. The expreion labelled (ii) i zero and he global economy i on he cup of abiliy/inabiliy, given he underlying rucural parameer of he model and he moneary policy parameer, m 2. The haded area in he norh-ea quadran, labelled m > 0 and in he norh-we and ouh-ea quadran labelled, m < 0, repreen he combinaion of fical feedback parameer ha aify he inequaliie in (49) condiional on he ign of he moneary policy parameer, m. The non-haded area labelled m < 0 repreen he combinaion of fical policy parameer, again condiional on m, which aify he e of inequaliie in (50). (Recall ha hi econd e of inequaliie can only be aified in he preence of non- Ricardian conumer.) The oher area in he diagram, lying inide he lower hyperbola, repreen combinaion of policy parameer which canno uppor addlepah abiliy 3. 2 We have drawn he diagram auming ha he value of he aympoe i poiive, which eem plauible. However, our analyi i no maerially affeced by auming he oppoie. 3 Alhough he wo e of inequaliie can, poenially, be aified in hi region, numerical evaluaion of he eigenvalue ugge ha hee are no feaible combinaion of policy parameer for reaon ha are dicued below. 8

20 We fir conider he combinaion of fical policy which are required o uppor an acive moneary policy, m > 0, a hown by he haded area in he norh-ea quadran. There are everal feaure of hee abiliy condiion ha are worh emphaiing. Firly, he preence of non-ricardian conumer raie he hrehold level of fical feedback neceary o enure deb abiliy when moneary policy i acive. In he cae of Ricardian conumer he requiremen for he real deb ock o be bounded would imply be φ > r and φ > (a in Sim (997)) 4 r and he non-haded area in he norh-ea quadran would diappear. Thi would enure here wa no indefinie expanion of he real deb ock in eiher counry and ha here wa no indefinie ranfer of wealh from one counry o anoher. 5 The inuiion behind why he preence of non-ricardian conumer require larger fical feedback o abilie he deb ock i raighforward. Conider a poiive hock o deb. Wih non-ricardian conumer, hi will add o ne wealh and raie conumpion. Thi will, in urn, raie demand and inflaion, which wih an acive moneary policy will raie real inere rae, aggravaing he poenial deb-inere piral. A a reul, fical feedback ha o be greaer han he eady-ae real inere rae ince he acual real rae i above eady-ae. In our model, he condiion for individual deb abiliy are no only raied above hi hrehold, bu hey depend upon he fical repone of oher moneary union member a well a he acivim of moneary policy. The olid recangular hyperbola in he norh-ea quadran race he combinaion of fical feedback ha are neceary o enure ha a addlepah-able raional expecaion equilibrium exi wih uainable level of deb in boh economie. Therefore, even when we impoe he condiion ha deb in each counry hould be able, a well a in aggregae, here i cope for compenaion beween fical auhoriie. However, he degree of rade-off i non-linear any counry no doing enough o abilie i deb ock will require a far greaer repone from he oher counry o enure bounded real deb ock in each individual economy. Addiionally, here are limi o he degree o which one counry can compenae anoher. If one auhoriy ha a fical repone which i le han he value of he aympoe, 4 Thi condiion i ronger han ha oulined in Canzoneri e al (2000) where he fical auhoriie mu imply make ome aemp o repay any deb inere which i rolled over from previou period, bu hi aemp can be arbirarily mall and infrequen. The difference arie ince Canzoneri e al (op. ci.) wih o define he condiion under which he economy operae under a Ricardian Regime, while Sim (op. ci.) give condiion under which fical policy enure ha he real deb ock i bounded (for a reconciliaion of hee wo view ee Cochrane (998)). A we are examining he dynamic abiliy of an economy where finie conumer live imply ha deb coniue an elemen of ne wealh, adoping a combinaion of moneary and fical policy rule which enure ha he real deb ock i abilied i he only way o enure a dynamically able economy. 5 If we were imply inereed in he iue of price level deerminacy wih abiliy of he aggregae deb ock, hen he uual condiion would be φ + φ > r and here would be a raigh rade-off 2 2 beween he fical repone of he wo auhoriie. 9

21 τ g N g kk ( + σ ) αα ( + r) m( + ( )) rc N y (5) 2 N g r( r σ) αα ( r) m( ( )) N y and he moneary auhoriy i acively argeing inflaion, hen i will no be poible for anoher fical auhoriy o compenae no maer how grea heir fical repone, wihou accumulaing he deb of he lax fical auhoriy. Addiionally, a can be een from he dependence of hee aympoe on he moneary policy parameer, m, he greaer he degree of acivim in moneary policy he greaer he required fical repone o abilie he repecive economie deb ock. Finally, i hould be noed ha alhough hee are neceary, bu no necearily uffic ien condiion, numerical evaluaion of he eigenvalue of he raniion marix for plauible parameer value ugge ha hee neceary condiion are alo ufficien. The nex cae we conider i he ouh-we quadran. Here neiher fical auhoriy i aemping o abilie i deb ock, or i doing o weakly. However, in hi cae numerical evaluaion of he eigenvalue of he raniion marix ugge ha even if hi policy combinaion can aify he inequaliie in (49), he economy i never addlepah able. The inuiion i quie raighforward a ingle moneary policy canno enure fical olvency under wo independen fical auhoriie when hoe wo auhoriie boh fail o ac o abilie heir deb ock. Thi reul alo applie in he cae of Ricardian conumer and flexible price ince a ingle price level canno adju o enure ha he budge conrain of wo independen fical auhoriie are aified (ee Canzoneri e al (200)). We can, herefore, ignore hi combinaion of policy parameer in examining able policy pace. In he preence of non-ricardian conumer hi policy-pace acually exend ou of he ouh-we quadran. If he economy i operaing in he non-haded area lying below he lower hyperbola, hen even alhough one fical auhoriy i operaing wih a fical feedback parameer, φ > r or φ > r, which exceed he uual abiliy condiion in he cae of Ricardian conumer, i i ill inufficien o abilie he deb ock when conumer are non-ricardian. Eenially, boh fical auhoriie remain unable o abilie heir deb ock. We can alo examine he cae where he moneary auhoriy i able o compenae for a weak fical repone on he par of one fical auhoriy by operaing a paive moneary policy. Thi i given by he area lying beween he wo hyperbola. Here one fical auhoriy i acing o abilie i deb ock. The oher fical auhoriy hen ha o ac o enure deb abiliy on i own a noed above he moneary auhoriy canno ac o abilie he deb of wo impruden auhoriie. I i alo inereing o noe ha when one fical auhoriy pah for deb i only mildly unable hen he pruden fical auhoriy ha o have a very large degree of fical feedback o enure addlepah abiliy. 20

22 Thi analyi ugge ha we can idenify wo underlying policy regime. Firly, for moneary policy o be able o adju nominal inere rae uch ha real rae are free o rie in repone o exce inflaion hen i i neceary for each fical auhoriy o be adjuing heir fical inrumen o enure he value of i real deb ock i bounded. Wihin hi regime here can be ome degree of compenaion beween fical auhoriie, in ha a moderae fical repone on he par of one fical auhoriy will no compromie he ECB aemp o arge inflaion if anoher fical auhoriy i ufficienly aggreive in abiliing i ock of governmen liabiliie. The econd regime we can idenify, i where one fical auhoriy doe no mee he criical degree of fical feedback needed o abilie i deb ock when he ECB gear moneary policy oward he conrol of inflaion. In hi cae he ECB mu abandon i aemp o acively conrol inflaion and adop a moneary policy which will no deabilie he deb ock of he recalciran fical auhoriy. The remaining fical auhoriie mu ac o abilie heir own liabiliie i would only be poible for he ECB o ai more han one fical auhoriy if heir policie, heir economie and he hock hiing hem were perfecly ymmerical. Any oher combinaion of policy i unuainable in ha here would be indefinie ranfer of wealh beween union member. 3.Calibraion and Simulaion of he Model: In order o dicu he policy implicaion for differen degree of fical reciude under a common moneary policy, we need o adop parameer value for our model. We aume ha a uni of ime correpond o a quarerly daa period. Accordingly, he parameer we chooe are given in Table, along wih he eady-ae value hee imply. Table Parameer and Seady-Sae Parameer Value Variable Seady- Sae Value Seady-Sae Value a percenage of annual GDP q 8 y % σ r (annualied) 0.03 N.A. k h % τ 0.25 a = l.4 70% α c % κ.36 g % χ 0.00 m % 2

23 The value of he elaiciy of demand facing our imperfecly compeiive firm, θ, come from he economeric work of Roemberg and Woodford (998). The coninuouly compounding quarerly dicoun rae of i lighly lower han ha implied by oher udie (uch a Kollman (998) or Roemberg and Woodford op. ci., for example). The reaon for hi i ha hee udie aume infiniely lived conumer o ha heir implied coninuouly compounding rae of i equivalen o an annualied real inere rae of around 3%. Since he exience of finie live in our model raie he real rae of inere above conumer rae of ime preference, hi lighly lower rae of ime preference i conien wih he ame equilibrium real inere rae. The k parameer i he probabiliy of deah for our conumer. Thi value implie ha conumer have an expeced working life of 30 year. Alhough hi may be hough o imply an implauible value for he probabiliy of deah, i i neceary o generae a plauible eadyae value of governmen deb relaive o GDP he implied deb o GDP raio of 70% i he ame a for he Euro area in 2000 (ECB (200)). Thi mark-up can be juified a reflecing uncerainy no formally capured in our model. For example, Faruqee e al (997), how ha aking he probabiliy of deah ory lierally implie near Ricardian conumpion behaviour. They hen how ha exending he model o allow for non-monoonic life-ime earning profile effecively raie he inere rae mark-up in he equaion for aggregae human wealh in a manner conien wih our calibraed parameer. τ i our level of lump um axaion and implie ha ax revenue are 25% of GDP. The κ parameer i choen uch ha conumer devoe 50% of heir waking hour o leiure and 50% o work. While he parameer α meaure he inananeou probabiliy ha a firm will be able o ree i price. Therefore, α meaure he average lengh of ime beween price change. A value of 3.5 α =, mean ha i ake, on average, 0.5 monh for firm o ree price. Thi figure i half way beween he 3 quarer (ee Roemberg and Woodford (997), for example) and year (ee Erceg e al (200)) expeced conrac lengh commonly adoped in he lieraure. I i alo conien wih economeric eimae of hi parameer for he Euro area in Gali e al (200) and Leih and Malley (200). We conider wo value for m, he coefficien on exce inflaion in he Taylor rule. The fir value of m of 0.5 i widely ued in udie of inere rae reacion funcion; ee Taylor (993) for example. We conra hi wih a value of -0.5 hi implie a moneary policy which only adju nominal inere rae by half he rie in inflaion uch ha real rae fall. Finally, we aume, ha he parameer governing he imporance of money in uiliy i 0.00, implying ha he ock of governmen liabiliie iued in he form of cah or depoi 22

24 i 2.7% of GDP, relaive o overall governmen liabiliie of 70% of GDP. Again hee figure are conien wih he Euro area a he end of 2000 (ECB (200)). Thi parameeriaion, herefore allow a mall role for eigniorage revenue in he analyi ha follow. The eady-ae hee parameer imply i hown in he righ-hand-ide of he able. The real inere rae ha an annualied value of around 3%, and he eady-ae raio of deb o GDP i around 70%, which i conien wih figure for he Euro area economie. The raio of governmen pending o GDP of ju under 25% i alo ypical of European economie if you eliminae ranfer from he definiion of governmen pending o be lef wih governmen conumpion a defined in our model (ee Gali (994), for a comparion of hi raio acro OECD economie). We can now conider he implicaion of our abiliy analyi given he aumed parameer of our model. Numerical evaluaion of he abiliy condiion deailed above, indicae ha if boh fical auhoriie ran policie uch ha φ > and φ > (i.e. for every one Euro of deb diequilibrium axe have o adju by a lea Euro) hen he moneary auhoriie would be free o acively arge inflaion. If one fical auhoriy failed o mee hi level of fical feedback hen he oher may be able o compenae for heir behaviour, alhough only in he range of < φ < 0.008, uch ha he moneary auhoriy could ill run an acive moneary policy. In oher word, alhough here i he heoreical poibiliy of one fical auhoriy compenaing for he lax fical behaviour of anoher, he range over which hi i poible i very mall, and could require a very large fical repone on he par of he compenaing auhoriy. Since he minimum degree of fical feedback required of each auhoriy i relaively low i eem far more likely ha he only uainable policy pace i if boh fical auhoriie ac o fulfil hi condiion leaving he moneary auhoriie o arge inflaio n. Simulaion: In hi ecion we analye he pah of aggregae variable in our wo economie in he face of hock under variou decripion of policy. The hock we conider i a fical hock which raie he real value of deb by 0%, ce. par 6. Figure 2 give he pah for inflaion, conumpion and deb when moneary policy acively arge inflaion, uch ha m=0.5, and he fical auhoriie ac o abilie deb in accordance wih fical feedback parameer of φ = φ = 0.. In oher word, given he eady-ae implied by our aumed model parameer, hey raie ax revenue by % for every % increae in heir liabiliie 6 To he exen ha he governmen liabiliie are denominaed in nominal erm, any urprie inflaion a a reul of he hock may reul in he iniial increae in deb being differen from 0%. 23

25 relaive o heir eady-ae value. Since he economie and he hock hiing hem i ymmerical, here i no diincion beween he pah of variable in counry and 2. The main hing o noe abou hee reul i ha even alhough conumer are non- Ricardian, and dicoun he fuure far more heavily ha an infiniely-lived conumer would, hi ill ha a negligible impac on conumpion and inflaion due o he acive repone of moneary policy. The iniial impac on inflaion i only 0.008% and conumpion only rie by 0.005%. In hi imulaion deb wa aumed o be fully indexed. However, when deb i denominaed in nominal erm he urprie inflaion aociaed wih he fical hock erve o reduce he iniial increae in he real value of deb. However, he increae in inflaion i o mall ha he effec are negligible. We can hen conra hee imulaion wih an example of our paive regime. Specifically, we aume ha he fical auhoriy in counry 2 refue o adju ax revenue in he face of deb diequilibrium i.e. φ = 0. The moneary auhoriy i hen forced o adop a moneary policy ha will enure deb abiliy in counry 2 we aume m=-0.5. Finally, he fical auhoriy in counry ac prudenly wih a fical feedback parameer of 0.. Figure 3 reveal he pah of inflaion, conumpion and governmen liabiliie in boh counrie when governmen deb i fully indexed and when i i nominal. In hee cae he impac of he ame fical hock on inflaion and conumpion i far more ignifican inflaion rie by almo 6% on impac and conumpion by almo 0% when deb i fully indexed, and by almo 4% and 7%, repecively when deb i nominal. The reaon i ha he ECB paive moneary policy doe no raie real inere rae in repone o exce inflaion a hi would lead o a deb inere piral in counry 2. Thi looening of moneary policy, boo he dicouned value of human wealh which increae conumpion. Given he nominal ineria in he wo economie hi will feed hrough ino boh higher conumpion and inflaion. The pah for governmen deb in he wo economie are lighly differen he acive fical feedback in counry abilie he deb ock more quickly, while uing moneary policy o abilie he deb ock in counry wo lead o liabiliie acually falling below arge afer ½ year. I hould alo be noed ha he differen fical policie alo imply differen pah for conumpion and inflaion in he wo economie conumer in counry uffer an increae in axaion which conumer in counry 2 avoid. However, a wa een in Figure 2 he impac on aggregae demand of deb, even wih hi degree of non-ricardian behaviour, i negligible, and i difficul o dicern from he graph. Figure 3, alo conain he pah for variable when deb i denominaed in nominal erm. Here, he iniial increae in deb i almo halved a a reul of he urprie inflaion induced by he fical hock. Thi i eenially he mechanim underlying he Fical Theory of he Price Level if price were fully flexible hen he fical hock could be compleely 24

26 eliminaed by a one-off jump in he price level. However, in he preence of nominal ineria, no all price are free o jump o eliminae he fical diequilibrium. A a reul, he moneary auhoriie ill need o ac paively o avoid an exploive pah for deb in counry 2, alhough he iniial urprie inflaion ha made heir job much eaier. Therefore, real inere rae need no fall by a much, and he lacker moneary policy doe no feed conumpion and inflaion o he ame exen. Thee reul ugge ha i i deirable o enure ha he moneary union i in he acive moneary policy regime, bu ha mode fical feedback i ufficien o inure ha deb diequilibrium doe no have a ignifican impac on inflaion. Wha would be he conequence of one economy abiliing deb much more rapidly, while adjumen in he oher economy remained mode? If he mode repone of one fical auhoriy impoed ignifican co on he oher economy, hen hi may erve a a raionale for he Pac for Sabiliy and Growh. To anwer hi queion, he final imulaion we conider are he cae of he ECB engaged in he figh again inflaion, m=0.5, while he fical auhoriy in counry arge i deb ock wih he fical feedback parameer φ = 0., bu counry 2 employ an exremely aggreive fical policy, φ = 9.4, adjuing ax revenue by 00% for every % deviaion of public liabiliie from heir eady-ae value. Figure 4 deail he pah of inflaion, conumpion, governmen liabiliie and privae ecor financial wealh in he face of he ame fical hock. Again he magniude of he change in conumpion and inflaion are very mall for he reaon dicued above. The rong fical repone in counry 2 mean ha i deb ock i reurned o eady-ae very quickly. In counry he repone i more gradual. Thi mean ha conumpion in counry i given a greaer boo due o he relaive delay in fical correcion here. A hi increae in aggregae demand in counry feed ino demand for produc in boh economie price rie in boh economie. The ECB repond by raiing real inere rae, which parially offe he rie in conumpion in counry and acually reduce conumpion in counry 2. The iniial price increae in counry i greaer han in counry 2 a worker in counry require greaer wage increae o upply heir labour a hey now wih o ubiue heir higher conumpion for leiure. The pah for privae ecor financial ae reflec he pah for governmen liabiliie, alhough here i ome difference in he medium run a erm of rade effec reul in conumer in counry holding ome of he deb of counry 2. Thu, alhough differen peed of deb correcion lead o difference in repone beween counrie, he overall impac on inflaion i mall. Thi model doe no imply ha he enforcemen of rapid correcion of deb diequilibrium i neceary o abilie inflaion in a moneary union. 25

27 4.Concluion In hi paper we conruced a wo counry model which conained a number feaure which broke he diincion beween Ricardian and non-ricardian policie highlighed by he FTPL. Specifically, our wo economie feaured overlapping generaion of conumer who did no expec o live forever a a reul he governmen liabiliie (money and bond) coniue an elemen of ne wealh and heir level will affec real inere rae in our economie. Thee conumer hen upplied labour o imperfecly compeiive firm who old heir oupu a home and abroad. Thee imperfecly compeiive firm could only adju heir price a random inerval. The combinaion of non-ricardian conumer, and he nominal ineria facing imperfecly compeiive firm implied ha boh moneary and fical policy could have real and nominal effec in boh counrie. We hen analyed he rericion on policy neceary o enure ha our economie were addlepah able. In he conex of he dynamic yem analyed hi implie ha hee rericion would deliver a fully deermined pah for price and would alo preven indefinie ranfer of wealh from one economy o he oher. Depie he complexiy of he model we were able o derive a number of analyical reul. Fir, he degree of fical repone running from governmen deb o axaion required o enure ha he real deb ock i bounded i higher in he preence of non-ricardian conumer. Second, we were able o idenify wo underlying policy regime conien wih a fully deermined pah of price and able ock of deb in boh economie. In he fir regime he moneary auhoriie implemen a common moneary policy which raie nominal inere rae, uch ha real inere rae rie in repone o exce inflaion. Thi acive argeing of inflaion require he fical auhoriie o ac o abilie heir liabiliie. However, i wa poible for one fical auhoriy o compenae, o ome exen, for a relaively weak fical repone on he par of anoher moneary union member. In he econd policy regime, one fical auhoriy did no ac o abilie i liabiliie, and he oher fical auhoriy wa unable o compenae for hi behaviour wihou ranferring he wealh of i ciizen abroad. In hi regime, he only way o abilie deb in boh economie i for he moneary auhoriy o abandon i acive argeing of inflaion uch ha increae in inflaion will reduce real inere rae and abilie he deb in he counry which run an oherwie deabiliing fical policy. The remaining fical auhoriie mu hen enure ha heir fical policie abilie heir repecive real deb ock. Finally, we calibraed he model and generaed a plauible eady-ae. We found, for plauible parameer value, ha he cope for one fical auhoriy o compenae for weak correcion on he par of he oher wa very limied. However, he degree of fical feedback required o enure a able pah for he real deb ock wa no very onerou. I alo uggeed ha difference in he peed of fical correcion, once hi criical rae wa reached, are no 26