Mark-up fluctuations and fiscal policy stabilization in a monetary union

We study optimal monetary and fiscal stabilization policies in a two-country, microfounded model of a monetary union featuring price rigidities, monopolistic competition and (inefficient) mark-Lip shocks. With symmetric rigidities, fiscal policy is not employed in stabilizing union-level variables. Countries' relative spending levels, however, are used to stabilize relative inflation rates and the terms of trade. Under commitment, both monetary policy and relative spending are inertial, while this is not the case under discretion. Numerical analyses indicate substantial welfare gains from commitment and from fiscal stabilization. We conclude by investigating some simple monetary and fiscal policy rules. (C) 2003 Elsevier Inc. All rights reserved.