Fiscal Policy and Inflation in a Monetary Union

We study optimal fiscal policies in a small monetary union country. The government uses nominal non-state-contingent debt and distortionary labour taxes to finance exogenous spending. Price levels differ across countries due to consumption home bias; thus fiscal policy influences inflation and the terms of trade. Prices are flexible. We show that, unlike in a country with an independent monetary policy, some variability in labour taxes is optimal. With nominal public debt there is an incentive to use taxes to inflate in bad times when debt levels are high, reminiscent of the optimal monetary policy result of Chari etal. ().