Interest rates, exchange rates and fiscal policy in Europe: the implications of Maastricht

This paper addresses the issue of fiscal solvency and the debt sustainability in a potential European Monetary Union using a forward looking, estimated neoclassical model of the World Economy. The implications of fiscal shocks to the European economies is analysed. Money base targetting is used in combination with a set of fiscal closure rules that ensure that the "no Ponzi-games” condition holds. The model as a result has a saddlepath and it is possible to solve with forward looking expectations. After discussing model properties the paper offers a suggestion for standardised analysis of fiscal policy on forward looking models.  Changes in the target government deficit and sustained but ultimately transitory effects on output and unemployment. However, the costs of a contraction are not negligible. The paper draws some conclusions on the effects of the Maastricht fiscal solvency criteria.