United we stand: on the macroeconomics of a Fiscal union

In this paper, we apply dynamic tracking games to macroeconomic policy making in a monetary union. We use a small stylised nonlinear two-country macroeconomic model of a monetary union for analysing the interactions between two fiscal (governments: "core" and "periphery") and one monetary (central bank) policy makers, assuming different objective functions of these decision makers. Using the OPTGAME algorithm, we calculate numerical solutions for cooperative (Pareto optimal) and non-cooperative games (feedback Nash). We show how the policy makers react to adverse demand shocks. We investigate the consequences of three scenarios: decentralised fiscal policies controlled by independent governments (the present situation), centralised fiscal policy (a fiscal union) with an independent central bank (pure fiscal union), and a fully centralised monetary and fiscal union. For the latter two scenarios, we demonstrate the importance of different assumptions about the joint objective function corresponding to different weights for the two governments in the design of the common fiscal policy. We show that a fiscal union with weights corresponding to the number of states in each of the blocs gives better results than non-cooperative policy making. When one bloc dominates the fiscal union, decentralised policies yield lower overall losses than the pure fiscal union and the monetary and fiscal union.