Optimal Fiscal Currency in a Monetary Union with Sovereign Debt and a Banking Sector

Abstract

This paper examines the effectiveness of various simple optimal policy rules for a monetary union with financial frictions. In order to do so, we construct a two country DSGE model with financial frictions in the form of a financial accelerator and bank capital channel as in the literature. We then consider various formulations of optimal simple rules. In doing so, we show that there are large gains in using more active optimal fiscal policy that responds to domestic economic indicators to stabilize output and inflation in monetary unions. We find that including foreign economic indicators in the optimal policy rule in addition to domestic ones provides on modest gains to stabilization. We then analyze the response to debt in optimal fiscal rules and find that it is quite a bit larger than what has been found previously in the literature. Finally, we note that within the context of the model it does seem to be the case that the government’s optimal response to debt seems sensitive to parameterization of the financial accelerator and indeed increases as the level of financial frictions rises.