On January 1, 1999 the euro was launched as an electronic currency and on January 2002 euro notes and coins started circulating in twelve European Union countries. The adoption of the euro has tremendous benefits, but it also entails inflation, conflicts between fiscal and monetary policy, and fiscal financial risks. We investigate whether inflation in European Monetary Union (EMU) countries experienced a structural break after the euro was introduced. We find evidence that the EMU countries experienced a positive break in inflation after 1999. Next, we show that for the monetary authority to have the freedom to control price, the primary surplus must respond strongly enough to lagged debt. Using panel cointegration and panel techniques we estimate the coefficients of the error correction model for the primary surplus in a panel of ten EMU countries over the period 1970-2006. The group-mean panel estimate for the coefficient on lagged debt is consistent with the hypothesis that the monetary authority can control the price level in the EMU, independent of fiscal influence. Finally, we consider the risk of a fiscal financial crisis in the EMU under alternative fiscal responses. Using the panel estimates of the parameters in the surplus rule and initial values for government debt and the primary surplus, we simulate fiscal risk. We find that countries with initial values within the Maastricht limits are safe, while countries like Italy and Greece, in which their debt has strayed far above these limits might not be.
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