Fiscal Federalism and Monetary Unions by Rafael Berriel, Eugenia Gonzalez-Aguado, Patrick J. Kehoe, Elena Pastorino published NBER (12/2023).
We apply ideas from fiscal federalism to reassess how fiscal authority should be delegated within a monetary union. In a real-economy model with fiscal externalities, in which local fiscal authorities have an informational advantage about the preferences of their citizens for public spending relative to a fiscal union, a decentralized regime is optimal for small federations of countries, whereas a centralized regime is optimal for large ones. We then consider a monetary[1]economy model, in which governments finance their expenditures with nominal debt, and inflation has a negative impact on aggregate productivity. When the monetary authority lacks commitment, the resulting time inconsistency problem generates an indirect endogenous fiscal externality. When a country-level fiscal authority chooses a higher level of nominal debt, it induces the monetary authority to inflate more to reduce the level of distortionary taxes needed to finance the higher debt. The resulting fiscal externality naturally becomes more severe as the number of countries in the monetary union increases. Here also a decentralized fiscal regime is optimal for small monetary unions, whereas a fiscal union is optimal for sufficiently large ones. Our key result is that as the size of a monetary union increases, it becomes relatively more desirable to centralize fiscal authority.