EMU and the International Monetary System

13 How Will the Euro Behave?

Thomas Krueger, Paul Masson, and Bart Turtelboom
Published Date:
September 1997
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Daniel Cohen

There is little doubt that the making of monetary integration in Europe will have major effects on the exchange markets. Quoting one European currency rather than six or twelve should matter. But how? In which direction should we expect the euro to go? The conventional wisdom is that the euro will be a “strong currency.” For one thing, it should mimic the deutsche mark, typically a strong currency in its own right; second, it should attract new portfolio investors, bidding up its demand and raising its price; and third, it might have to go through a period during which the new monetary authorities will have to demonstrate their willingness to be “tough,” hence appreciating the currency at least for a while.

All these points are well known, and fairly extensively discussed in daily appraisals of the euro. The feature that I want to stress here is of a different nature: I want to emphasize the effect of the new conduct of monetary and fiscal policy upon the euro. Not only will monetary policy behave differently, by definition, but fiscal policy itself will change its course, and the new design of economic policy will have major influences on the value of the euro.

Building upon previous work with Charles Wyplosz (Cohen and Wyplosz, 1995), I will attempt to understand the likely implications of these policy regime shifts upon the value of the euro. As I will show, there are few reasons to believe that the euro will be less volatile than European currencies today. This will first be demonstrated theoretically. The core of the argument is as follows: since Europe as a whole is less open than the representative European country, monetary policy will be less constrained than it is now by trade disequilibria. This will make it less accommodative, hence making the euro potentially more volatile. The argument is sometimes known as the effect of a new “benign neglect” of Europe toward the euro, as it will become a “closer” economy (see Bergsten’s paper in this volume). The paper will qualify this view. First, openness needs to be defined by the degree of substitutability of European goods with the “rest of the world” products rather than through the mere average of imports or exports to GDP. Second, I will also show that being less open will imply a more volatile exchange rate in response to one kind of shock—those regarding price determinations (Phillips curve shocks), rather than those affecting aggregate demand. In the last part of the paper I will offer some empirical simulations regarding the value of the euro. I will first demonstrate that its current value is fairly well explained by the macroeconomic “fundamentals” of Europe, and I will then move to simulate the effects of a less accommodative monetary policy toward these shocks. Although these simulations are simply illustrative, they are suggestive of the fact that the euro might become more volatile than are European currencies today.

Theoretical Framework

I elaborate here upon a model of exchange rate behavior and policy design that is developed in Cohen and Wyplosz (1995).

Assume that the world is composed of three countries: Germany and France, which are assumed to be two identical countries, and the rest of the world (ROW), whose currency is called the “dollar.” Let e be the (log) of the nominal exchange rate of the franc with respect to the deutsche mark, and let e1 (e2) be the (log) of the nominal exchange rate of the franc (deutsche mark) with the dollar. We then have

We assume that each country produces a representative product whose price is p1 in France, p2 in Germany, and p0 in the ROW. Competitiveness is defined as

z(t) is the competitiveness of France with respect to Germany, z1(t) is that of France with respect to the ROW, and z2 (t) is that of Germany with respect to the ROW. We clearly have

I shall describe the economy through two equations, which I will refer to as a price and a demand curve. The price curve is a Phillips curve that is written in each of the two countries as

in which πi is inflation in country i and Qi is the log of the level of output in that country. εi(t)(i = 1,2) are two white noise disturbances.

As a simple way to understand this equation, assume that output is produced by mixing foreign and domestic (intermediate) goods. Call x1 the (log of the) nominal price of the intermediate good in France and e + p0 and e + p2 the (log of the) price of the two imported goods. If domestic prices are written as a flexible markup above cost and a random disturbance, one can then write

in which α + β + γ = 1. One can then write

that is,

Now assume that the price of the intermediate good is contracted at the beginning of the period and set by producers so as to guess the coming period’s price. One can then write

One then obtains, with obvious changes of notations, the Phillips curve equation that we postulated above.

In the sequel, we shall make the assumption that πc = 0. We shall justify this assumption in the next section. Otherwise the model can be taken as a model in which inflation is simply “surprise” inflation.

The second equation that we are dealing with is a demand curve that writes output as a function of competitiveness and fiscal stimuli:

in which Ai(t) measures the fiscal stimulus that country i implements.

I will stick here to a static version of the model, and all disturbances are assumed to be white noise disturbances. The full-fledged dynamic model presented in Cohen and Wyplosz (1995) would have the same implications. For simplicity, I will assume that the authorities can act directly upon two instruments: inflation (π) and fiscal stimulus (A).

As a simple way to see how the model is solved, let us take for the time being the case of Europe as a whole, in those circumstances where the economies are perfectly symmetric, leading to an equilibrium value z = 0. With zero expected inflation, the European economy boils down to

For a given value of π and A, output and competitiveness are determined simultaneously. Diagrammatically this can be solved as shown in Figure 1.

Figure 1.Output and Competitiveness

Any positive price shock ε > 0, if unaccommodated, brings the economy from a point A to a point B: output shrinks and competitiveness is reduced. Any negative demand shock η < 0, instead, if unaccommodated, brings the economy from a point A to a point C: output shrinks, but competitiveness rises. The economics of these shifts are fairly straightforward. A negative domestic demand shock is partially accommodated by a reallocation of domestic output toward foreign markets, and hence by increased competitiveness. By contrast, a negative price shock brings in foreign products and hence tends to lower competitiveness.

One can immediately see the impact of accommodating the shocks through monetary and fiscal policy. First, consider a price shock ε > 0. If it is accommodated by monetary policy, the economy might be brought back to its initial level. So, in response to a price shock, an accommodating monetary policy reduces the volatility of the exchange rate and of output. If instead the price shock is accommodated by fiscal policy (in order to limit the output decline), then clearly this will raise the volatility of the exchange rate: the initial decline in competitiveness brought about by the price shock will be exacerbated by an expansionary fiscal policy. Clearly, the opposite will happen when dealing with a demand shock: if accommodated by fiscal policy, one will reduce the volatility of the economy (output and exchange rate), while the volatility of the exchange rate will be raised if the demand shock is accommodated by monetary policy.

Let us now analyze in detail what are the optimal responses of monetary and fiscal policies to these shocks, and how monetary integration will change them.

Exchange Rate Volatility and Design of Economic Policy

Let us focus for the time being on the response of French and German policies to a symmetric shock: ε1 = ε2 = ε; η1 = η2 = η. I assume that the ROW is purely passive.

Let us assume that monetary and fiscal policies are designed in such a way as to

subject to the price and demand equations.

Let us briefly explain such an optimization problem. In the standard monetary policy game, such as developed in Barro and Gordon (1983), the monetary authorities would typically solve

in which Q* is (the log of) a full-employment (full-capacity) target level of output. Such objective would typically imply a systematic inflation bias that is expected by the private agents and has no effect on the equilibrium level of output. From an ex ante point of view, the optimum way to achieve the objective that is stated above is to scale down the target level Q* to a lower level Q0 that is consistent ex ante with zero inflation. The value Q0 is simply the output equivalent of the “natural rate of unemployment.” From the policymaker perspective, this implies an expansionary policy when output is below Q0 and a restrictive policy when output is above Q0. Such will then be our hypothesis: that policymakers are committed to implement their ex ante best policy response to unexpected shocks. We shall then simply normalize Q0 to be zero (all values are in logarithm) and therefore interpret Q as the deviation (in log terms) from the “natural rate of output.” Correspondingly, we assume that the Phillips curve that we deal with is associated with zero expected inflation. Our analysis consequently does not tackle the role of “credibility” that the implementation of the new ECB would have to tackle. Clearly, within our formulation, such an issue would involve analyzing the credibility issue through the additive term encompassed in the expected rate of inflation, but would not change the implication that we are dealing with so far as the response to unexpected shocks is concerned.

Another difference between the standard Barro-Gordon model and our analysis involves the role of the fiscal stimulus A. The weight ϕ0 that is attached to its implementation may be interpreted as the effect of distortionary taxation on the welfare of the economy. In the full-fledged dynamic model analyzed in Cohen and Wyplosz (1995), it also embodies the weight of the intertemporal budget constraint.

As a start to the analysis, let us first compute the outcome of fully cooperative policymaking. Recognizing their symmetry, French and German policymakers adopt the same decisions π1 = π2 = π and A1 = A2 = A and internalize the fact that their equilibrium real exchange rate will not vary, that is, they design their policy under the assumption that z = 0.

The problem can then be written as1

The first-order conditions are then written:

For convenience, we drop the country-identifying subscripts on Q and A. Eliminating λ and μ, thus yields two equations:

Equation (1) simply reflects the set of preferences of the policymakers. In response to any shock (ε,η), monetary and fiscal policy will partially absorb the shock to the best of their willingness to do so, which is measured by (ϕ10), and to the best of the efficiency of their instrument, measured by (b,g).

Equation (2) specifies how monetary and fiscal policy share the burden of the adjustment. Putting these two equations together, we can simply write:

Clearly, when either 1/ϕ1 or l/ϕ0 is zero, the policymaker will not respond through the corresponding instrument: it is simply too costly in terms of welfare. Similarly, the bigger g is, the more efficient is fiscal policy and the larger will be the fiscal policy response.

The interesting parameter that will be key to the forthcoming analysis is the ratio a1/h1. When a1/h1 is big, fiscal policy will be highly responsive and monetary policy will be kept low. The intuition behind this result can be traced back to the first-order conditions derived from the optimal exchange rate response to a shock. Ceteris paribus, accommodating a shock through monetary policy will involve a depreciation of the currency that will have spillover effects on demand. Raising inflation by 1 percentage point will de-predate the currency by 1/a and raise demand h/a. If h/a is high, or 1/a low, monetary policy can achieve two goals at the same time: stabilizing the Phillips curve and accommodating demand. It will be a perfect instrument that dominates fiscal policy.

The other (symmetrical) way of looking at the question is to analyze the consequences of raising the fiscal stimulus: it appreciates the currency by 1/ h and offsets inflation by a/h. If the number is high, then fiscal expansion achieves two goals—stabilizing supply and demand—and it will be the perfect instrument to stabilize output.

Solving the model altogether, one can then substitute π and A for their equilibrium value and solve the two-equation system.

If we call

we obtain the following equilibrium:

The solution fits the intuition that we obtained from Figure 1. In response to a positive price shock (i.e., one that reduces output, ε > 0), output contracts and the real exchange rate appreciates (competitiveness is reduced). In response to a negative demand shock (η < 0), output shrinks but the exchange rate is depreciated. The more responsive monetary and fiscal policy are (low ϕ0 and ϕ1), the more output will be stabilized. Let us see the implications for exchange rate volatility.

First, consider a price shock (ε > 0). Tough fiscal policy (1/ϗ0 is low) lowers the volatility of exchange rate, while tough monetary policy (1/ϗ0 is low) raises the volatility of the exchange rate. The intuition follows from what was said. By accommodating a price shock through monetary policy, a central bank would dampen the effect of the shock on the exchange rate. This fits the conventional wisdom (à la Volcker or Tietmeyer): tough central banks increase exchange rate fluctuations.

Instead, tough fiscal policies would lower the volatility of exchange rates originating from price shocks: if they were to intervene, they would add, as we have seen, another wave of disturbances to the original one. This was the Reagan approach that accompanied the Volcker shock: loose fiscal policy boosted output but increased the volatility of the exchange rate.

Exchange Rate Volatility and (Lack of) Coordination

Let us now investigate in detail how EMU will affect the strategic interactions between European policymakers. In this section we shall deal with a symmetric shock ε = ε1 = ε2; η = η1 = η2 affecting Europe. We deal with asymmetric shocks in the Appendix.

Let us first analyze the noncooperative outcome of a game in which each country picks a strategy πi*,Ai* that is the best response to the other country’s choice.

When determining its own choice, a country, say country 1, is subject to the following model originating from country 2:

When account is taken of the identity z2=z1z, country 1 calculates the intra-European exchange rate as:

in which f(ε, η) depends upon the response given by country 2 to the shocks (ε, η) while θ is a constant:

This implies that the model under which country 1 operates is written:

Clearly, under this model, the same first-order conditions will apply as those we obtained in the one-country framework set up in the previous section.


One obtains the following monetary and fiscal policy response:

In order to obtain the equilibrium itself, one will recognize that the equilibrium value of intra-European competitiveness, z, is nil by symmetry of the responses.


One can then write the outcome of the Nash game among European policymakers as

The comparison of this equilibrium to the one-country model set up above will then simply depend upon the comparison between a1/h1 and a1 + θ a/h1 + θh, which itself will simply depend upon the comparison between a1/h1 and a/h. We then have two cases.

  • a1/h1 < a/h is a case in which the goods purchased abroad are relatively more substitutable to the domestic goods than the goods purchased in Europe.

  • a1/h1 > a/h is the opposite case. It is reasonable to assume that such is indeed the relevant case. Intuitively, Europe is a market in which “trade effects” matter relatively more than “price effects” because the substitutability between European products is higher than that between goods from a particular European country and goods from the rest of the world. This is demonstrated empirically in Cohen and Wyplosz, 1991, and I will return to it in the section on empirical implications. In the sequel we shall then assume that


To see the implications of such an inequality, let us first compare the policy outcome that is reached under the Nash equilibrium to the one-European country model. Inequality (8) implies that g(θ) = a1 + θa/h1 + θh is a decreasing function of 8. We then have it that

Δ̂ is then higher or lower than Δ depending upon the relative weight of 1/ϕ0, and 1/ϕ1, and this will be reflected in the volatility of output. When fiscal policy is more active than monetary policy (g20 is high), then Δ̂ will be lower than Δ and output will be more volatile in a noncoordinated Europe than in a one-government Europe. In order to understand the intuition behind such a result, let us investigate the effects of a lack of coordination upon the exchange rate. The result is nonambiguous: in response to a price shock, the lack of coordination will lower the volatility of the exchange rate, while in response to a demand shock, the lack of coordination will raise the volatility of the exchange rate.

The intuition behind this result goes to the root of the problem of designing an optimal policy response in Europe. The lack of policy coordination leads each European policymaker to overstate the trade effects of exchange rate volatility relative to their price effects.

When acting on their own, European policymakers fear the intra-European trade disequilibria that an independent economic policy could trigger: they fail to acknowledge the fact that a symmetric shock makes such fears irrelevant at the aggregate level. As a result, as evident from equations (6), monetary policy will be overly active, while fiscal policy will be underresponsive. This is why, when fiscal policy is the dominant feature of economic stabilization (g20 is high), economic stabilization will be reduced and output will be more volatile. More specifically, consider the implications of a positive price shock (ε > 0). Because monetary policy is too responsive, the shock will be more dampened than it needs to be. By exaggerating the trade effect, uncoordinated policymakers will fail to appreciate the European currency against the rest of the world.

Consider now the effect of a demand shock. Here the opposite happens. In their attempt to stabilize the shock, each European policymaker fears trade disequilibria and underreacts to the shock, hence underadjusting the exchange rate response.

We can summarize these results as follows. Lack of coordination leads European policymakers to underadjust to demand shocks and to overadjust to price shocks. At the root of this mismanagement stands an overly responsive monetary policy and an unduly inactive fiscal policy. As a result, exchange rate volatility will be too low in response to price shocks and too large in response to a demand shock.

Since we want to focus on the euro question, only symmetric shocks are relevant for our analysis here. Indeed, asymmetric shocks, defined as ε1 = −2and η1 = − η2 would cancel out for Europe as a whole so that the net effect of such shocks on the competitiveness of Europe with the rest of the world is necessarily zero. At this stage, however, it might be important to stress that opposite results would apply in the case of asymmetric shocks so far as the response of each instrument is concerned. In such cases (which we analyze in the Appendix), policymakers fail to internalize the fact that their European counterparts move in a direction that is exactly opposite to theirs. In that case, monetary policy is too tight and should be loosened, while fiscal policy needs to be tightened. This might sound like the Stability and Growth Pact, whose validity, it then seems, would only be relevant for the kind of shocks that were experienced in the 1990s.

Implications of Monetary Integration

We are now in a position to understand the effect of monetary integration on the design of economic policy. In our framework, when dealing with symmetric shocks, monetary union is simply interpreted as the design of a joint monetary policy that sets π1 = π2 = π* for the zone as a whole, while we keep fiscal policy uncoordinated.

Building upon the distinction between a1/h1 and â/ĥ that was spelled out earlier, it is straightforward to see that monetary policy will be designed so as to accommodate output shocks along the following lines:

while fiscal policymakers, instead, failing to fully internalize the symmetry of the shocks, will design the following response:

While the fiscal response is therefore unchanged, monetary policy will be less accommodative under a monetary union than it is currently in response to a symmetric shock. This is not the effect of a change in policy preferences. Indeed, in our framework, we assume that policy preferences are unchanged. Rather, it is the outcome of a change in incentives. When policymaking is designed cooperatively, as will automatically be the case so far as monetary policy is concerned, policymakers can internalize the fact that a symmetric shock will have no effect on intra-European competitiveness. They are therefore less worried about letting competitiveness fluctuate: this will “only” trigger trade disequilibria with the rest of the world (which is less responsive to shifts in competitiveness).

As a result, one gets an equilibrium that will be intermediate, between the one-European country outcome and the Nash equilibrium across the two countries. If we call

the new equilibrium will be characterized as

The comparison between monetary union and the Nash equilibrium is now unambiguous, both with respect to output and with respect to exchange rates. One can indeed observe, first, that

so that output is always more volatile under a monetary union. The reason is straightforward, and the intuition should be clear by now. Monetary union leaves the fiscal policy response unchanged, while it tightens monetary policy: output will then be more volatile, but this will nevertheless raise the welfare of Europe.

If we turn to exchange rate volatility, the outcome will clearly depend upon the nature of the shock. In response to a price shock, the lack of a strong monetary response will raise exchange rate volatility, while in response to a demand shock, EMU will dampen exchange rate volatility.

There is then no a priori reason to believe that the euro will be a more “stable” currency than its European predecessors. Only if we trust that we are entering into a world where price shocks (such as those encountered in the 1970s) are a thing of the past while key fluctuations would now originate from demand shocks will such expectations materialize.

Empirical Implications

Let us now try to put some empirical flesh upon the previous reasoning. Our goal here is not to give precise results on the likely behavior of the euro, but rather to give some order of magnitude of the effects that we have been discussing. We first tried to get estimates of what we called price and output shocks and measure their influences on exchange rates. Previous estimates of so-called output and demand shocks have already been offered by Bayoumi and Eichengreen (1993). The question of the relationship between exchange rate and macroeconomic imbalances is also addressed in Canzoneri, Vallés, and Viñals (1996). Our strategy here is to try to estimate as closely as possible the model that is represented in the text. As we shall now see, it works fairly well empirically.

Let us first deal with price shocks. Assume that πe = ρπ −1 + (1 − ρ)π*. Our model can then be estimated as

in which z is taken to be the deviation of the current exchange rate with respect to purchasing power parities (Summers-Heston data) and Qt represents the deviation of output from potential output (such as measured by the OECD).

We then run the following output regression:

in which Qt and zt are defined as before and At is the structural fiscal deficit (such as measured by the OECD).

We use a panel model with fixed effects. All such regressions are obtained through instrumental variables in which the instruments are the lagged values. The sample of countries includes the following European countries: Denmark, Finland, France, Germany, Italy, Portugal, Spain, Sweden, and the United Kingdom. We obtain the following results (with t-statistics in parentheses):

for Equation (9):

and for Equation (10):

Except for h, which is only significant at the 10 percent confidence level, one sees that all coefficients are significant and fit the intuition spelled out in the text.

The regressions were run for European countries only. When we include all OECD countries, the most significant change is in h, which becomes wrongly signed (but is insignificant). We interpret this as a confirmation of the view that European countries are relatively more dependent upon trade effects than other countries.

From Equations (9) and (10) we can reconstruct the price and output shocks. If we call Tπ the time dummies of the price equation and TQ the time dummies of the output equation, the price and output shocks are (for each individual country) Tπ + εi(t), and TQ + ηi(t), respectively. For Europe as a whole they simply boil down to Tπ and TQ We represent these in Figures 2 and 3. As we see, and as should be expected, price shocks were more pronounced in the 1970s, while output shocks were more pronounced in the 1980s. More specifically, we can decompose the period into three subperiods. During the second half of the 1970s, price and demand shocks were both positive; according to the theory, this leads unambiguously toward a loss of competitiveness and this is indeed what we observe. During the first half of the 1980s, the shocks were both in the opposite direction, leading unambiguously to a rise of competitiveness. This is again what we observe: in the second half of the 1980s, the shocks were in opposite directions: price shocks remained negative, raising competitiveness, while demand shocks were positive, reducing competitiveness. The outcome is theoretically ambiguous, but the observed pattern is in favor of demand shock effects.

Figure 2.European Price Shocks

Figure 3.European Demand Shocks

To investigate empirically whether exchange rates can be tracked as the outcome of these shocks, we ran a regression in which the average value of European competitiveness is regressed upon the average value of the price and demand shocks: in brief, we simply estimated an equation such as (7b). The result is as follows (with t-statistics in parentheses and N denoting the number of observations):

As expected, a price shock ε > 0 lowers competitiveness, as does a demand shock where η > 0. Both coefficients are highly significant and the quality of the fit is excellent (see Figure 4). It is interesting that including a lagged value of competitiveness in the regression (to account for a mean reverting process as in Rogoff, 1996) does not raise the quality of the fit and makes the lagged value of z insignificant. We find these results encouraging: they seem to imply that exchange rates are driven by the macroeconomic fundamentals that our model suggest.

Figure 4.Actual and Estimated Values of the Euro

As a simple way to assess the implication of these results for the euro, we have plotted, in Figure 5, the net effects of price and output shocks on the exchange rate such as are captured by the above equation. We see that each shock appears to carry the same weight in the final outcome, and follows the loose characterization that we sketched out above regarding the effects of price and output shocks on exchange rates.

Figure 5.Contribution of Price and Demand Shocks to the Value of the Euro

As an illustration of the impact of a “tough” monetary policy, we have simulated the optimal policy response for the case when the preferences of the government are characterized by l/ϕ1 = 0. This means that, under our simulation, fiscal stabilization is as important as output stabilization, while monetary policy is assumed to be absolutely passive. Using the value of the parameters a,h, and g that we estimated, we find feedback values of 6.3 and 1.95, for price and demand shocks, respectively. The results are shown in Figure 6, in which we also plot the response obtained from our econometric equation. In such a simulation, competitiveness may fluctuate by as much 40 percent instead of the 20–25 percent fluctuation that was obtained in the past. Although clearly only a very ad hoc estimate, this sheds some light on the potential effect of a nonaccommodating monetary policy upon the volatility of exchange rates.

Figure 6.Value of the Euro With and Without Monetary Accommodation


Although our results are still preliminary, they point to a simple conclusion. Price and demand shock management stands at the core of the determination of the real exchange rate. Any tightening of monetary policy carries the risk of raising the volatility of the real exchange rate if price uncertainties are dominant, while it would reduce the volatility if demand volatility is dominant. The conclusions fit what a naive observation of the dollar would imply. Economic policies become bolder in their management of the exchange rate when trade disequilibria are feared less. To summarize this result, we may say that the “benign neglect” of U.S. economic policy toward the dollar may also become, for the same reasons, the attitude of European policymakers toward the euro (see the papers in this volume by Bergsten, and by Bénassy-Quéré, Mojon, and Pisani-Ferry in this volume, for a similar interpretation). In some circumstances (European domestic price volatility), this is likely to create more exchange rate volatility.

Appendix Asymmetric Shocks

We have dealt in the text with the response of European policymakers to European-wide shocks. Let us now investigate the outcome of an asymmetric shock. (This distinction is also critical in the pioneering work of Canzoneri and Gray, 1985). More specifically, consider one of the following shocks:

which neutralize each other at the European level. Here, because of the symmetry of the economies, whatever the response of the European policymakers,

or in other words, whatever one country gains in terms of competitiveness will be lost by the other.

Consider the outcome of the noncooperative game in which each country retains its sovereignty over both instruments. The same reasoning as before applies so far as the perception of each policymaker is concerned. The response of each policymaker to the shock is still characterized by equations (6). The difference is that the equilibrium is now a solution to


then the outcome of the noncooperative game among European policymakers should be written as

It is straightforward to compare this noncooperative equilibrium to the outcome of the cooperative equilibrium if θ = 2 in the definition of

Under these assumptions the first-best outcome is characterized by

Under our (maintained) hypothesis that a/h < a1/h1, one obtains

This shows that, contrary to the outcome of a symmetric shock, fiscal policy is too expansionary in the noncooperative case, while monetary policy is too cautious when coordination is lacking. As we have already stressed, this will imply that exchange rates will be too volatile in response to a price shock and too stable in response to a demand shock.

The intuition is clear. When they act noncooperatively, European policymakers fail to internalize the fact that their European counterparts move in a direction that is opposite to theirs. In other words, more weight than what they perceive should actually be given to intra-European disequilibria (which is clearly the opposite of the case of a symmetric shock). If trade effects are relatively more important within Europe than are price effects, this implies that monetary policy should be loosened, while fiscal policy should be tightened. This sounds like a “fiscal stability pact” cum a laxer monetary policy, which is perhaps what the stability pact is about. It would then be only valid in cases of asymmetric shocks, which were indeed dominant in the 1990s, but need not be so in the future.

The author thanks Helene Poirson and Delfim Neto for their brilliant research assistance.

Here, the first-order optimality condition is set simultaneously by “the” policymaker. But it would not change the analysis to assume that each instrument is determined by two independent branches of the government, provided that each of these branches (determining respectively monetary and fiscal policy) has full information on the other one’s decision.


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