Quantitative easing rules as a means to achieve optimal levels of structural reforms and government deficits in a monetary union

Abstract

This paper uses a tractable game theory model to study the interactions of structural reforms and fiscal and monetary policies in the European Monetary Union (EMU). Considering the externalities that arise when interest rates have hit the lower bound and monetary policy is carried out through quantitative easing (QE), we show that the subgame perfect equilibrium is suboptimal when structural reforms and fiscal policy are implemented at a national level. Then, we prove that the optimal outcome cannot be obtained if structural reforms are dictated by a supranational institution. By contrast, we establish that the first best can be obtained either by a full-fledged fiscal union or a rule on QE. Given the practical difficulties that the first of these two solutions have encountered in the EMU, a rule over QE provides a clear, easier and more credible way to make structural reforms and fiscal deficits achieve the levels that maximise the union's welfare.