FISCAL AND MONETARY-POLICY IN A MONETARY UNION - CREDIBLE INFLATION TARGETS OR MONETIZED DEBT

The paper examines the interrelationship between fiscal and monetary p olicy in a two-country monetary union. The worst scenario occurs when an independent central bank sets the nominal interest rate and respond s to rising government debt/GDP ratios by monetization. The result is high inflation, high debt/GDP ratios and a large public sector. Govern ment debt and inflation are contained if the governments bear sole res ponsibility for solvency, but the public sector remains excessively la rge. The best scenario occurs if the central bank removes the incentiv e for the governments to engineer surprise inflation by credible infla tion targeting.