The unbearable tightness of being in a monetary union : fiscal restrictions and regional stability

We study how constrained fiscal policy can affect regional inflation and output in a two-region model of a monetary union with sticky prices and distortionary taxation. Both government expenditure and taxes can be used to stabilize regional variables; however, the best welfare outcome is obtained under constant taxes and constant regional inflations. With cooperation debt and deficit constraints reduce regional inflation variability, but the path of output is suboptimal. Under non-cooperation the opposite occurs due to a trade-off between taxation and inflation variability. Decentralized rules, rather than constraints, stabilize regional inflation and output. They imply more fiscal action for smaller union members.