Working Paper: CEPR ID: DP8918
Authors: Wendy Carlin
Abstract: In terms of macroeconomic performance, the Eurozone?s first decade is a story of successful inflation-targeting by the ECB for the common currency area as a whole combined with the persistence of real exchange rate and current account disequilibria at member country level. According to the standard New Keynesian model of a small member of a currency union, policy intervention at country level is not necessary to ensure adjustment to country-specific shocks. Self-stabilization of shocks takes place through the adjustment of prices and wages to ensure that the real exchange rate returns to equilibrium. That this did not happen in the Eurozone appears to be related to the presence of non-rational wage-setters in a number of member countries. A related second departure from the New Keynesian model was the transmission of nonrational inflation expectations to the real interest rate, propagating easy credit conditions in countries with inflation above target. Problems of real exchange rate misalignment among members were exacerbated by the ability of Germany?s wagesetting institutions to deliver self-stabilization. The implications for policy focus on using fiscal policy to target the real exchange rate and / or on reforms to labour markets that deliver real exchange rate oriented wage-setting.
Keywords: Eurozone; Fiscal Policy; New Keynesian Model; Real Exchange Rate; Wagesetting
JEL Codes: E61; E62; E65; F41; O52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| non-rational wagesetting (J31) | persistent inflation differentials (E31) |
| non-rational wagesetting (J31) | current account imbalances (F32) |
| rational wagesetting (J38) | self-stabilization (C62) |
| self-stabilization (C62) | return to equilibrium (D50) |
| non-rational wagesetting (J31) | necessity of fiscal policy for stabilization (E63) |
| fiscal policy (E62) | targeting the real exchange rate (F31) |
| real interest rate channel (E43) | difficulties in stabilization (C62) |
| inflation persistence (E31) | easy credit conditions (E51) |