Journal of Macroeconomics 26 (2004) 377–379

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Discussion

Comments on ‘‘Mark-up fluctuations andfiscal policy stabilisation in a monetary union’’

Frank Smets *

Germany Directorate General Research, Principal––Monetary Policy Research Unit,

European Central Bank, P.O. Box 16 03 19, D-60066 Frankfurt am Main, Germany

Available online 25 January 2004

It is a pleasure to discuss this paper, which is part of the authors’ broader research

program on fiscal policy stabilisation and coordination in a monetary union. The pa-

per is a nice example of how modern micro-founded macro-models can be used to do

a rigorous welfare analysis of various macro-policies. The paper is a companion to

the earlier work of the authors (Beetsma and Jensen, 2002), in which they use a

framework developed by Benigno (in press). Benigno’s model consists of a monetaryunion of two countries, each with a representative household. Because of perfect risk

sharing, consumption bundles are equalised across the two countries. All goods are

traded and are produced in a monopolistically competitive sector, of which n goods

are produced at home and (1� n) are produced abroad. Nominal rigidities in the

goods sector are modelled as in Calvo (1983). The main difference with Benigno

(in press) is the introduction of a government-provided consumption good in the

households’ preferences in each of the two countries. Because the national govern-

ment can choose how much to produce of this good, it provides an additional toolfor economic stabilisation. However, such stabilisation involves a trade-off between

the optimal provision of government consumption as dictated by the households’

preferences and economic stabilisation. The main difference with the authors’ earlier

work is twofold. First, the authors introduce exogenous mark-up fluctuations in

addition to productivity shocks. Second, they derive a quadratic approximation of

the weighted average of the utility of the representative households in both countries

and use this welfare criterion to analyse optimal coordinated fiscal and monetary

policy. The latter follows the work of Woodford (2003).How useful is this set-up to study fiscal policy stabilisation in a monetary union?

It is clear that many of the issues observers of European Monetary Union (EMU)

have in mind when thinking about the conduct of fiscal policy in a monetary union

* Tel.: +49-69-1344-6550; fax: +49-69-1344-6575.

E-mail address: frank.smets@ecb.int (F. Smets).

0164-0704/$ - see front matter � 2003 Elsevier Inc. All rights reserved.

doi:10.1016/j.jmacro.2003.11.010

378 F. Smets / Journal of Macroeconomics 26 (2004) 377–379

cannot or are not dealt with in this paper. For example, the authors do not discuss

the issue of fiscal policy coordination across countries. Is it optimal to coordinate

fiscal policy in the presence of fiscal policy externalities? If so, what form should this

coordination take? Neither do they address political economy issues as, for example,

in Dixit and Lambertini (in press). If fiscal and monetary authorities have differentobjectives, what is the appropriate institutional framework? Finally, the model does

not explicitly incorporate government debt. Moreover, Ricardian equivalence holds.

It is thus not suitable to be used for analysing issues such as the sustainability of debt

and the possibility that fiscal policy dominates in the determination of the price level.

However, the framework is well-suited for studying the implications of inflation dif-

ferentials for optimal monetary and fiscal policy in a monetary union. In particular,

the paper addresses the question: How should government spending respond to na-

tional inflation differentials due to asymmetric productivity and cost-push shocks?This issue is, of course, of great relevance in the EMU, where significant inflation

differentials exist, although the size of those inflation differentials are similar to those

observed in the United States, a much longer established monetary union.

Turning to the results, one very nice finding of the paper is that under symmetry––

i.e. with equal rigidities in both countries––the full two-country optimal fiscal and

monetary policy problem can be separated into two surprisingly simple problems:

an aggregate monetary union problem and a relative problem. The main result from

the monetary union problem is that aggregate government spending should equal itsefficient level. There is therefore no role for aggregate fiscal policy in stabilising the

aggregate monetary union economy. This task is dealt with by the monetary author-

ities which set policy as in Woodford (2003)’s closed economy. The only difference is

that inflation varies inversely with the aggregate consumption gap rather than the

output gap. Moreover, as in Woodford (2003), monetary policy exhibits history

dependence under commitment. In sum, according to this model, the ECB should

focus on aggregate variables and not worry about relative inflation differentials.

How robust is this finding? Clearly, if rigidities and/or the transmission mechanismdiffer across the two countries, this result may be overturned. For example, Benigno

(in press) has shown that the central bank should put more weight on inflation in the

country with the greater degree of nominal rigidity. 1 Moreover, if there are signif-

icant non-linearities, for example due to downward nominal rigidities in wages

and prices, then again these results may be overturned.

The message from this paper for the EU fiscal authorities is that, while they

should refrain from using government spending for EU-wide stabilisation purposes,

national fiscal policy is the most efficient instrument to deal with inflation differen-tials in a monetary union. However, the optimal response of government spending

depends on the shocks driving the inflation differentials: relative productivity or

mark-up shocks. In order to gain further insight in the optimal response, it would

be nice to see the impulse responses of relative government spending to those shocks.

Under commitment, government spending should be increased in response to a

1 See Benigno and Lopez-Salido (2002) for an empirical application to EMU.

F. Smets / Journal of Macroeconomics 26 (2004) 377–379 379

positive relative productivity shock. In contrast, government spending should be

reduced in response to a positive relative mark-up shock. The intuition is straightfor-

ward. In the presence of nominal rigidities, a positive productivity shock will lead to

a negative output gap and a gradual fall in prices. In order to stabilise the economy,

the fiscal authorities can increase domestic government spending, thereby increasethe demand for domestic labour and offset the fall in prices. Opposite optimal

responses are necessary when cost-push shocks drive down inflation. Of course,

one obvious question one may raise in this context is to what extent government

spending is the most efficient instrument. In particular, as variations in government

spending will have a cost in terms of welfare, other fiscal policy instruments such as

time-varying corporate taxes or subsidies may be more appropriate.

Another result worth emphasising is that the gains from commitment and fiscal

stabilisation appear substantial. However, the benefits from fiscal policy stabilisationdisappear when the mark-up shocks are perfectly correlated. Finally, under discre-

tion, the losses are lower when policy is constrained, than when fiscal policy is

unconstrained.

Let me end my discussion with some questions: First, why do the authors not con-

sider the distortion coming from monopolistic competition? It would be interesting

to see how much this would affect the comparison of commitment and discretionary

policies. Second, what do we know about the preferences for the type of goods that

the government produces. How sensitive are the results to reasonable calibrations ofthe utility function in this respect? Finally, it would be interesting to extend the ana-

lysis of simple fiscal policy rules to rules that respond to inflation and the terms of

trade.

References

Beetsma, R., Jensen, H., 2002. Monetary and fiscal policy interactions in a micro-founded model of a

Monetary Union. Universities of Amsterdam and Copenhagen, Mimeo.

Benigno, P., in press. Optimal monetary policy in a currency area. Journal of International Economics.

Benigno, P., Lopez-Salido, D., 2002. Inflation persistence and optimal monetary policy in the euro area.

ECB Working Paper 137, September 2002.

Calvo, G., 1983. Staggered prices in a utility-maximising framework. Journal of Monetary Economics 12,

383–398.

Dixit, A., Lambertini, L., in press. Interactions of commitment and discretion in monetary and fiscal

policies. American Economic Review.

Woodford, M., 2003. Interest and Prices. Foundations of a Theory of Monetary Policy. Princeton

University Press, Princeton, NJ.