DP1909 | Workers' Versus Bankers' Europe (II): Policy Externalities and Credibility in EMU

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In this paper we analyse how the creation of a single currency regime changes the strategic relationship between policy-makers, both within and across countries. In particular we look at the role of cross-country externalities and lack of commitment. When labour taxation is excessive, due to terms of trade externalities, the European Central Bank (ECB) may be tempted to raise inflation above the flexible exchange rate equilibrium in order to induce governments to substitute seignorage for income taxes. Therefore the equilibrium rate of inflation in EMU typically exceed the flexible exchange rate level. When the ECB cannot credibly commit to inflation, multiple equilibria may arise, where inflation is excessive and labour taxes too low (Workers? Europe), or vice versa, where taxation is excessive and inflation too low (Bankers? Europe). Finally, if the ECB cannot commit to a fixed scheme for redistributing seignorage, the outcome is excess inflation and suboptimal taxation. Both governments anticipate that the ECB will redistribute seignorage in favour of the country with lower tax revenue, and tend to lower tax rates accordingly.