Fiscal Moral Hazard due to Monetary Integration
We develop a model in which a single currency plays the role of medium of exchange in two countries, while their governments are free to determine their fiscal balance and the extent to which they need to extract seigniorage from the common currency. We show that the actions of each government affect the economic performance of the other country, due to their trade relationship and, mostly, due to their monetary integration. We then endogenize each government’s fiscal policy, and find that in equilibrium they will choose higher deficits than if they did not share a currency. Moreover, their policy choices are inefficient in the sense that if they could negotiate and commit their fiscal policy, they would choose smaller deficits. The inefficiency is worst if one of the partners is very small, or very unproductive, relative to the other, as the moral hazard on the smaller or poorer government would be larger
Trejos, A, & Hernández, A. (2012). Fiscal Moral Hazard due to Monetary Integration. Monetaria, 35(1), 63–85.