Co-Ordinating Fiscal Authorities in the Eurozone: A Key Role for the ECB

This paper examines the conditions for fiscal restraint to emerge as Nash equilibrium in the game between fiscal authorities in a monetary union and discusses the implications for the ECB's monetary strategy. We show that fiscal authorities fail to internalize the adverse area-wide effects of their policies when the ECB targets union-wide aggregates. To address this co-ordination failure, we propose that the ECB reacts to fiscal restraint by implementing a monetary reward. Applying the pareto- and risk dominance criteria to the ensuing co-ordination game, we show that the ECB can ensure convergence upon fiscal restraint by adopting a weakly countercyclical reaction function.