Monetary and fiscal policy rules in the european economic and monetary union: A simulation analysis

Optimal monetary and fiscal policies within the European Economic and Monetary Union (EMU) are determined by simulating a global model under alternative assumptions about the objective function of the European Central Bank (ECB) and about cooperation vs. non-cooperation with fiscal policy-makers. In particular, strategies involving: (a) a money supply target, (b) tracking European inflation, (c) stabilizing European nominal income, and (d) fixing the exchange rate of the Euro with respect to the Dollar are evaluated and compared with respect to the associated welfare effects. The results show the high effectiveness of fixed rules in the presence of supply side shocks and the usefulness of cooperative discretionary measures against demand side shocks. Nominal income targeting by the ECB has to be regarded as inferior to inflation targeting, while fixing the exchange rate leads to quite satisfactory results in most cases.