Determinacy and learning stability of economic policy in asymmetric monetary union models

Abstract

This thesis examines determinacy and E-stability of economic policy in monetary union models. Monetary policy takes the form of either a contemporaneous or a forecast based interest rate rule, while fiscal policy follows a contemporaneous government spending rule. In the absence of asymmetries, the results from the closed economy literature on learning are retained. However, when introducing asymmetries into monetary union frameworks, the determinacy and E-stability conditions for economic policy differ from both the closed and open economy cases. We find that a monetary union with heterogeneous price rigidities is more likely to be determinate and E-stable. Specifically, the Taylor principle, a key stability condition for the closed economy, is now relaxed. Furthermore, an interest rate rule that stabilizes the terms of trade in addition to output and inflation, is more likely to induce determinacy and local stability under RLS learning. If monetary policy is sufficiently aggressive in stabilizing the terms of trade, then determinacy and E-stability of the union economy can be achieved without direct stabilization of output and inflation. A fiscal policy rule that supports demand for domestic goods following a shock to competitiveness, can destabilize the union economy regardless of the interest rate rule employed by the union central bank. In this case, determinacy and E-stability conditions have to be simultaneously and independently met by both fiscal and monetary policy for the union economy to be stable. When fiscal policy instead stabilizes domestic output gaps while monetary policy stabilizes union output and inflation, fiscal policy directly affects the stability of monetary policy. A contemporaneous monetary policy rule has to be more aggressive to satisfy the Taylor principle, the more aggressive fiscal policy is. On the other hand, when monetary policy is forward looking, an aggressive fiscal policy rule can help induce determinacy.