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Thursday, December 10, 2015

'Competitiveness: Some Basic Macroeconomics of Monetary Unions'

Simon Wren-Lewis:

Competitiveness: some basic macroeconomics of monetary unions: From comments on an earlier post, it is clear how many people do not understand how a monetary union works..., I thought a brief primer might be useful.
We need to start with the idea that for a country with a flexible exchange rate, you will not increase your international competitiveness by cutting domestic wages and prices. The reason is that the exchange rate moves in a way that offsets this change. ... So if wages and prices fall by, say, 3%, then the Euro will appreciate by 3%.
So what happens if just one country within the Eurozone, like Germany, cuts wages and prices by 3%. ...Germany gains a competitive advantage with respect to all its union neighbours of 3%, plus an advantage of 2% against the rest of the world. Its neighbours will lose competitiveness both within the union and to a lesser extent against the rest of the world. ...
The Eurozone as a whole gains nothing: the gains to Germany are offset by the losses of its union neighbours. ...
One of the comments on this earlier post said that there was nothing in the ‘rules’ to prevent this, the implication being that therefore it was somehow OK. But it must be obvious to anyone that this kind of behaviour is very disruptive, and hardly compatible with Eurozone solidarity. ...
What you could do, to incentive governments, is establish fiscal rules based on inflation differentials of the kind described here. That would have meant that as relative German inflation rates fell, the government would have been obliged to take fiscal (and perhaps other) measures to counteract it.... But if rules of this kind had been on the table when the Euro was formed, I’ll give you one guess about which country would have objected the most.

    Posted by on Thursday, December 10, 2015 at 10:25 AM in Economics, International Finance | Permalink  Comments (24)


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