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How to Restore Sustainability of the Euro?

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  • Alho, Kari E.O.
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    Abstract

    We reassess the result of unsustainability of the euro with respect to inflation differentials claimed by Wickens (2007) by specifying an open-economy version of a two-region New Keynesian model for EMU and demonstrate that the result by Wickens does not hold in general. We are able to derive a result that the model is determinate for a wide range of policy rules so that the sustainability of the euro area and the member countries is reached over time with respect to supply and demand shocks and emerged imbalances in price levels and competitiveness. We then enlarge the numerical analysis to consider EMU and sustainability in the case, prevailing currently, where a high debt country should both restore its competitiveness and its fiscal balance, and the policies re-quired from the single monetary policy and the national fiscal policies. Strong fiscal consolidation and far-reaching successful structural reforms are needed to reach sustainability in the sense that emerged imbalances in competitiveness and price levels and the threat of ever mounting debt levels could be eliminated over the medium run. We also illustrate how the current deflationary adjustment involves a major polarisation in economic developments within the euro area.

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    Bibliographic Info

    Paper provided by The Research Institute of the Finnish Economy in its series Discussion Papers with number 1259.

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    Length: 32 pages
    Date of creation: 2011
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    Handle: RePEc:rif:dpaper:1259

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    Keywords: EMU; euro; sustainability; fiscal policy; competitiveness;

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    1. Thomas Laubach, 2009. "New Evidence on the Interest Rate Effects of Budget Deficits and Debt," Journal of the European Economic Association, MIT Press, vol. 7(4), pages 858-885, 06.
    2. Tatiana Kirsanova & Campbell Leith & Simon Wren-Lewis, 2009. "Monetary and Fiscal Policy Interaction: The Current Consensus Assignment in the Light of Recent Developments," Economic Journal, Royal Economic Society, vol. 119(541), pages F482-F496, November.
    3. Galí, Jordi & Monacelli, Tommaso, 2005. "Optimal Monetary and Fiscal Policy in a Currency Union," CEPR Discussion Papers 5374, C.E.P.R. Discussion Papers.
    4. Simon Wren-Lewis & Campbell Leith, 2007. "Fiscal Sustainability in a New Keynesian Model," Economics Series Working Papers 310, University of Oxford, Department of Economics.
    5. Sophocles Mavroeidis, 2010. "Monetary Policy Rules and Macroeconomic Stability: Some New Evidence," American Economic Review, American Economic Association, vol. 100(1), pages 491-503, March.
    6. Wickens, Michael R, 2007. "Is the Euro Sustainable?," CEPR Discussion Papers 6337, C.E.P.R. Discussion Papers.
    7. Ferrero, Andrea, 2009. "Fiscal and monetary rules for a currency union," Journal of International Economics, Elsevier, vol. 77(1), pages 1-10, February.
    8. Patrick Minford & Naveen Srinivasan, 2011. "Determinacy in New Keynesian Models: A Role for Money after All?," International Finance, Wiley Blackwell, vol. 14(2), pages 211-229, 06.
    9. Andreas Schabert & Sweder J.G. van Wijnbergen, 2011. "Sovereign Default and the Stability of Inflation Targeting Regimes," Tinbergen Institute Discussion Papers 11-064/2/ DSF20, Tinbergen Institute.
    10. Mike Wickens, 2010. "Is the Euro the Success that Everyone Seems to Think?," Open Economies Review, Springer, vol. 21(1), pages 183-185, February.
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