Working Paper BETA #2007-13

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Title : Financial Integration and Fiscal Policy Efficiency in a Monetary Union

Author(s) : Gilbert Koenig, Irem Zeyneloglu

Abstract : The gap between the interest rates of different members of the European Monetary Union (EMU) points out to an imperfect degree of financial integration despite the common currency. This paper develops a two-country New Open Economy Macroeconomics (NOEM) model with imperfect financial integration in a monetary union in order to analyze fiscal policy efficiency and the impact of financial integration on the international transmission of fiscal policy shocks. For this, we introduce imperfect financial integration into the fixed exchange rate version of Obstfeld-Rogoff (1995, 1996). We show that a higher degree of financial integration decreases short run consumption and interest rate volatility in both countries while it increases the volatility in the long run following a balanced-budget increase in government spending in one of the countries. In terms of welfare, the degree of financial integration is irrelevant since it has no effect on the utility of the members.

Key-words : New open economy macroeconomics, fiscal policy, financial integration, monetary union

JEL Classification : F41, E44, E62