Working Paper: CEPR ID: DP358
Authors: Frederick van der Ploeg
Abstract: This paper analyses and compares the effects of common demand and supply shocks on the setting of optimal monetary policies under a clean float, a managed exchange rate system (such as the EMS) and a monetary union, when welfare depends on unemployment and the cost of living. The results suggest that monetary union yields the smallest welfare loss and a float the greatest, and that the EMS gives France and Italy the opportunity to appreciate their currencies and reduce their welfare loss at the expense of Germany. The robustness of the results with respect to rational expectations and wage-price dynamics is verified with the aid of differential game theory and numerical simulation.
Keywords: EMS; EMU; macroeconomic interdependence; policy coordination; monetary policy
JEL Codes: 430
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| adverse demand shock (E00) | monetary policy expansion (E63) |
| adverse supply shock (E00) | need for international policy coordination (F42) |
| tight monetary policies (E52) | unemployment (J64) |
| floating exchange rate regime (F33) | no need for international policy coordination (under adverse demand shocks) (F42) |
| monetary union (F36) | smallest welfare loss (D69) |
| managed exchange rate system (F33) | larger welfare loss than monetary union (F36) |
| floating regime (F33) | larger welfare loss than monetary union (F36) |
| European Monetary System (EMS) (F33) | currency appreciation (for countries like France and Italy) (F31) |
| currency appreciation (for countries like France and Italy) (F31) | reduced welfare loss (at Germany's expense) (D69) |
| establishment of a federal fiscal authority (H69) | offset idiosyncratic shocks (E39) |
| full monetary union (F36) | more justified in presence of common shocks than idiosyncratic shocks (D80) |