Monetary-Fiscal Interactions and the Euro Area's Malaise

March 2016
Marek Jarocinski, Bartosz Mackowiak

When monetary and fiscal policy are conducted as in the euro area, output, inflation, and government bond default premia are indeterminate according to a standard gen-eral equilibrium model with sticky prices extended to include defaultable public debt. With sunspots, the model mimics the recent euro area data. We specify an alternative setup to coordinate monetary and fiscal policy in the euro area, with a non-defaultable Eurobond. Output and inflation become determinate in general and government bond yields in important cases. If this policy arrangement had been in place during the Great Recession and afterwards, output could have been much higher and inflation somewhat higher than in the data.