986 Matthew Canzoneri et al.

robust — most significantly the first two noted previously. Others are less so.50 On
the other hand, by using the same model, we are able to make consistent comparisons
that are not otherwise possible because the existing literature uses a variety of
models.
An additional reason for placing less emphasis on particular quantitative results is
that we use a linear approximation to the model around a nonstochastic steady state.
Chari, Christiano, and Kehoe (1995) provide examples of inaccuracies that can arise
when doing so. Albanesi (2003) argues that concerns about the methods we use can
be more serious because of the unit roots or near unit roots in the responses of key
var- iable to shocks. On the other hand, both Benigno and Woodford (2006) and
Schmitt- Grohe and Uribe (2004a) find that their log-linear approximations do not
suffer from accuracy problems. Benigno and Woodford (2006) examine the model
considered by Chari et al. (1995). They find that the numerical results they obtain
using their lin- ear-quadratic methods are quite close to those Chari et al. (1995)
report based on more computationally intensive projection methods, but substantially
different from those Chari et al. (1995) report based on log- linearization. Schmitt-
Grohe and Uribe (2004a) address accuracy concerns by comparing the moments
computed from exact solution of their model with flexible prices to those computed
from a log-linear approximation. They find the differences are small, except that the
approximate solu- tion produces an inflation volatility that is about one percentage
point too low. They cannot compute the exact solution of their model when prices are
sticky but they com- pare the moments computed from a first-order approximation to
the model with those computed from a second-order approximation in samples of 100
years. They argue that if the unit root behavior is a serious problem and over 100
years variables wander far from the point around which the model is approximated,
then the errors are likely to be considerably larger in the moments computed from
the second-order approxima- tion. They find the results from the first- and second-
order approximations are very close. Our reason for reporting moments computed
from simulated samples of 200 quarterly observations is the hope of mitigating these
problems.
We begin by considering the optimal choice of inflation and the tax rate on wage
income when profits are fully taxed. The implications for optimal inflation and
interest rates are summarized in Table 3 and Figures 7A and B. Not surprisingly, the
Friedman rule is optimal when prices are flexible. The nominal interest rate is zero in
every period so that both the average interest rate and its volatility are zero. Average
inflation is approximately -1% per quarter, which is approximately minus one times
the real interest rate (gross inflation in the nonstochastic steady state is equal to b).
Unexpected
50
For example, the incentive to use inflation to tax profits is robust, but the magnitude of steady-state inflation is not.
We find positive inflation is optimal when profits are less than fully taxed. Schmitt-Grohe and Uribe (2004b) find
that nominal interest rates are positive but that deflation (albeit less deflation than under the Friedman rule) is
optimal unless the elasticity of substitution between the intermediate goods is lower than our benchmark value.
When we consider a model similar to theirs, we replicate their results.
The Politics of Monetary Policy
1045

6.3 Political and monetary union

In addition to its economic costs and benefits, the monetary union in Europe has been
seen by many as an important step toward political unification. Therefore the benefits
of the euro include its help toward political integration.
This argument has two parts: one is that political unification is desirable and, second
that the Euro will help to achieve this goal. This is not the place to discuss in detail the
first point, but political unification in Europe seems to have stalled. 52 On the second
point, using the euro as a political tool to unify Europe raises a bit of healthy skepti-
cism. To begin with only a subset of EU countries have adopted the euro. Thus if
the euro is a symbol and a necessity for political union it would imply a very strange
“United States of Europe,” which would not include the UK, Sweden, and Denmark,
countries that are an integral part of the economic union. More generally Europe is
evolving into a collection of countries that share some policies (say monetary policies)
and a collection that shares other policies (say open borders for travelers, the Schengen
Treaty). The recent enlargement of the EU to 27 country members has made it less
likely that the degree of political integration will intensify due to the large differences
of member countries. Third, recent attempts to deepen political ties, like the adoption
of a European Constitution, have received limited support from European citizens.
Finally, every time a crisis hits Europe its institutions seem to take a secondary role.
For instance, for all the talk about fiscal coordination at the onset of the recent crisis
every country went on its own and there were hints of “beggar thy neighbor poli-
cies.”53 Rather than fiscal policy coordination, in 2008 and 2009 the feeling among
member countries was to make sure that nobody benefited by other countries expan-
sionary fiscal policies and the associated domestic debts. Foreign policy disagreements
and inability to act as a unit have been even more obvious. The EU has made impor-
tant progress in establishing a common market; eliminating some, but not all, ineffi-
cient government regulations; and promoting some reforms especially in goods
markets.54 This is all good, but it is well short of political union. In fact, one may won-
der whether political union would necessarily make reforms more or less likely to be
adopted. Some commentators argue that some of the reform policies promoted by
the European Commission, regarding avoidance of government subsidies, elimination
of indirect trade barriers, and so forth have occurred precisely because this body is
relatively nonpolitical and unresponsive to the European Parliament.55 The EU is

52
See Alesina and Perotti (2004) for a critical view of the process of European Unification. Issing (2010) also noted
how the euro will have to live without a political union behind it.
53
Ireland, for instance, at the onset of the crisis introduced emergency banking policies that negatively affected British
Banks.
54
See Alesina, Ardagna, and Galasso (2010) for a recent discussion of the effect of the euro adoption on labor and good
market reforms.
55
On these issues see Alesina and Perotti (2004) and several essays in Alesina and Giavazzi (2010).