Example: EMU Fiscal Policy
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Assume there is a negative demand shock in Portugal, not experienced in the rest of Europe. Output and inflation fall while unemployment rises in Portugal (see economic fluctuations). The ECB, however, does not use monetary policy to react to Portugal’s position as a Portuguese central bank would have. The ECB looks at the aggregate level of inflation and output, which does not capture the problems in Portugal. Portugal’s fall in inflation and rise in unemployment will have very little effect on Europe’s aggregate level.
In fact, if the shock were completely asymmetric, in that the rest of Europe had a positive demand shock while Portugal had a negative demand shock, the aggregate inflation rate would increase even though Portugal’s would decrease. If the ECB were to raise interest rates to lower aggregate inflation, it would amplify the negative demand shock in Portugal.
Even though the ECB may not respond to Portugal’s specific problem, the Portuguese government still has fiscal policy at its disposal. It can lower taxes or increase spending. As it does so, it will increase demand and cause an increase in output and inflation. The cost is a worsening of budgetary balances.