Introduction:

Macroeconomic policies in the Euro zone have to deal with countries whose structures will remain strongly heterogeneous for a while. The problem will become even more serious with the progressive enlargement of the Euro zone. Keynesian literature has paid little attention to the question of whether and how heterogeneity affects the effectiveness of the policy mix within a monetary union, although some important aspects have been tackled in Palley (2006) with regard to monetary policy. Heterogeneity matters, for example, because common shocks, which normally call for collective policy responses (like monetary policy), have asymmetric effects that normally call for individual policies (like national fiscal policies). Therefore, compared with the symmetric case considered in Asensio (2005b), monetary and fiscal policy interactions are reinforced in the face of heterogeneity. The problem is so complex because policy instruments (including national instruments) also have differentiated effects across countries.

This chapter addresses the question by means of both analytical and simulation tools which allow studying monetary and fiscal interactions according to different central bank ‘profiles’. Section 2 presents a twocountry Keynesian model (that is, a model in which unemployment does not spontaneously tend towards any ‘natural’ position) where the central bank, it is assumed, adjusts the rate of interest so as to stabilise the average price index, although it may concede some inflation depending on the relative importance of unemployment as compared with inflation. Governments on the other hand are supposed to aim at reducing unemployment without departing from their budget balance target. Furthermore, section 2 studies monetary and fiscal responses in the face of inherited unemployment and various current shocks. Section 3 explores how adverse interactions could be avoided and how, consequently, policy efficiency could be improved. The conclusion draws some lessons for a better co-ordination of macroeconomic policies in the Euro zone.