Abstract
After 10 years of the euro it is well documented that the paths and rates of growth differ among the countries of the zone. In particular, some countries experience a kind of a business cycle characterized with an economic slowdown or recession after a period of strong demand and overheating. This paper offers a theoretical explanation of these phenomena. I claim that nominal and real divergences in a monetary union are endogenous dynamics and not necessarily a result of any asymmetrical shocks. The paper develops micro-based, rational expectations model that presents inflation differentials, current account deficits and eventually ratcheting the economy down as an effect of joining a monetary union or–more specifically–of restrictions which a common currency puts on interest rates and exchange rate flexibility. Within this theoretical framework the results of economic policy in a monetary union may be suboptimal; the domestic product ends up below its potential level that the economy could attain at a flexible exchange rate and an individually set interest rate. This solution is an example of Nash equilibrium which is not Pareto optimal. It proves again that micro-optimization is not a substitute for a proper macroeconomic policy that should create the right conditions for decisions taken by individual agents. When representative agents differ among countries with respect to their inter-temporal preferences macro-policies should be “customized”, one size does not fit all. As a bonus, the conclusions of the paper also find an easy application to the business cycles typical for exchange rate based inflation stabilization programmes, an issue once extensively discussed in the literature. These cycles receive in the paper a coherent theoretical explanation with the same rationale that stands behind the description of nominal and real divergences in a monetary union.
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Notes
Compare Blejer, del Castillo (1996)
A formal presentation of exchange rate vulnerability would necessitate introducing stochastic shocks to the model.
It is not necessary but convenient to assume that all agents are identical in size. It would be enough to assume they have constant shares in production and consumption. There is no reason, either, to complicate the model by the introduction of any stochastic shocks.
The last assumption that prices never fall will be relaxed in the sixth part of this paper.
This assumption will be relaxed in the sixth part of this paper.
However, the solution to the problem is trivial as long as the analysis is restricted to the case of a monetary union or a fixed rate where the analyzed country “imports” (due to UIP) the foreign interest rate.
This nominal exchange rate divided by the level of the price of the complex domestic product (given fixed foreign prices) is also terms of trade.
As a consequence of the assumptions there is eventually no need for domestic credit. This feature of the model could be eliminated, for example, by introducing two “generations” of domestic agents. This would complicate the model and would not give any new insights to the problems it is intended to shed light on. It is important that the interest rate matter even in the present structure of the model with eventually no domestic credit. Each agent making individual decisions on his time pattern of spending of the predetermined income takes into consideration the level of the interest rate. In principle, he is free to lend or borrow domestically. Moreover the domestic interest rate determines through UIP the cost of foreign lending/borrowing. The quotas of agents’ spending depend on the interest rate.
If the respective equations reasonably represent the reality, there must be a solution which represents the real state.
The interest rate of the central bank is one for a very short–term and having only two periods (transaction sessions and a time span between them) in the model we mean rather distant horizons. A multi-period version of the model could do better with this respect – it should produce an equilibrium interest rate for each period what could be identified with the loss ( target) function of the central bank. However, when a small country in a monetary union is considered this problem is of little importance – interest rates, also for longer periods, are determined by the exogenous rates of the central bank of the union, here assumed as constant (compare footnote 9). In fact, in the EMU there is very little difference among national longer term interest rates despite major fundamental distinctions among the member countries.
This is a more complex issue; when the central bank’s target is macro-equilibrium in the sense applied in the model it means it does not concentrate its efforts on general price-level stability or inflation, it does not set the interest rate to eliminate the effects of exchange rate fluctuations on general price level. This is rather inconsistent with real-life monetary strategies under floating exchange rates (direct inflation targeting in particular).
For example, if the interest rate is below its equilibrium level there is inflationary pressure at the first moment. This can be eradicated due to real appreciation of the local currency. Since this is a situation of a trade deficit such appreciation in fact must result from inflation. This sets the real exchange rate for the first moment and – due to UIP – for the second moment. If there is deficient demand at the second moment neither the exchange rate nor sticky prices allow for a shift towards equilibrium. Moreover, the nominal exchange rate could not be fixed first with respect to equilibrium at the second moment since it would bring about even stronger inflation at the first moment – and the real exchange rate at the second moment would be too strong anyway. It is only unexpected devaluation (the breach of UIP) that could help with respect to the maintenance of equilibrium at the second moment. Also expectations of such a juncture could bring about positive risk premia and a rise in market interest rates. This should shift the economy closer to equilibrium. If these alternative mechanisms were not considered the situation when the domestic interest rate is fixed equal to the foreign rate should be identical with the case of a monetary union.
The exchange rate parity is set administratively after an economic consideration of its proper, sustainable equilibrium level. Equilibrium is widely defined as simultaneous internal and external equilibria and respectively the Swan diagram is applied to illustrate the idea of the fundamental equilibrium exchange rate (Williamson (1983)). This is the dominant intellectual device beyond determination of the level of a fixed rate. However it should be clear now that there is no sustainable equilibrium at a fixed rate or – to say the same differently – there is no equilibrium fixed rate but for the case when domestic equilibrium interest rate exactly matches the interest rate of the union. In this context it is worth noticing that the Swan diagram is a static device with unclear understanding of external equilibrium which does not explicitly recognize inter-temporal optimization.
Also in the theory of optimum currency areas the old argument of factor mobility must be applied with extreme caution; even if European employees were mobile it is difficult to imagine a country readily accepting a major outflow of its citizens and an economic shrinkage in the aftermath of a heavy asymmetric shock. European practice shows that it is equally improbable these migrants would be readily accepted.
To express it trivially Scots live mainly in Scotland and they care about the development of Scotland while Italians live mainly in Italy and they are interested in their country.
At constant domestic prices of import this means an increase in real wages. To keep things possibly simple we assumed that labor supply and production does not react to this change.
This is not incompatible with the assumption of inelastic supply of labor – an effect of a decline in the aggregate demand is disequilibrium in labor market (unemployment).
However, this particular case of identical results in the first period depends on the earlier assumption of θ = 1.
As long as we assume that inflation per se does not bring about real costs.
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Koronowski, A. Divergent business cycles as an effect of a monetary union. Int Econ Econ Policy 6, 103–113 (2009). https://doi.org/10.1007/s10368-009-0138-z
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DOI: https://doi.org/10.1007/s10368-009-0138-z