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Real exchange rate adjustment, wage-setting institutions, and fiscal stabilization policy: Lessons of the Eurozone’s first decade

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  • Carlin, Wendy

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8918.

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Date of creation: Mar 2012
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Handle: RePEc:cpr:ceprdp:8918

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Keywords: Eurozone; fiscal policy; New Keynesian model; real exchange rate; wage-setting;

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Cited by:
  1. Luigi Bonatti & Andrea Fracasso, 2012. "A Germans’ dilemma: save the euro or preserve their socio-economic model," Department of Economics Working Papers 1207, Department of Economics, University of Trento, Italia.
  2. Daniel Agyapong & Anokye M. Adam, 2012. "Exchange Rate Behaviour: Implication for West African Monetary Zone," International Journal of Academic Research in Accounting, Finance and Management Sciences, Human Resource Management Academic Research Society, International Journal of Academic Research in Accounting, Finance and Management Sciences, vol. 2(4), pages 215-228, October.

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