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The simple macroeconomics of North and South in EMU

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  • Jean Pisani-Ferry
  • Silvia Merler

Abstract

The euro area today consists of a competitive, moderately leveraged North and an uncompetitive, over-indebted South. Its main macroeconomic challenge is to carry out the adjustment required to restore the competitiveness of its southern part and eliminate its excessive public and private debt burden. This paper investigates the relationship between fiscal and competitiveness adjustment in a stylised model with two countries in a monetary union, North and South. To restore competitiveness, South implements a more restrictive fiscal policy than North.We consider two scenarios. In the first, monetary policy aims at keeping inflation constant in the North. The South therefore needs to deflate to regain competitiveness, which worsens the debt dynamics. In the second, monetary policy aims at keeping inflation constant in the monetary union as a whole. This results in more monetary stimulus, inflation in the North is higher, and this in turn helps the debt dynamics in the South.Our main findings are -The differential fiscal stance between North and South is what determines real exchange rate changes. South therefore needs to tighten more. There is no escape from relative austerity.If monetary policy aims at keeping inflation stable in the North and the initial debt is above a certain threshold, debt dynamics are perverse - fiscal retrenchment is self-defeating;If monetary policy targets average inflation instead, which implies higher inflation in the North, the initial debt threshold above which the debt dynamics become perverse is higher. Accepting more inflation at home is therefore a way for the North to contribute to restoring debt sustainability in the South.Structural reforms in the South improve the debt dynamics if the initial debt is not too high. Again, targeting average inflation rather than inflation in the North helps strengthen the favourable effects of structural reforms.

Suggested Citation

  • Jean Pisani-Ferry & Silvia Merler, 2012. "The simple macroeconomics of North and South in EMU," Working Papers 740, Bruegel.
  • Handle: RePEc:bre:wpaper:740
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    1. Günter Coenen & Christopher J. Erceg & Charles Freedman & Davide Furceri & Michael Kumhof & René Lalonde & Douglas Laxton & Jesper Lindé & Annabelle Mourougane & Dirk Muir & Susanna Mursula & Carlos d, 2012. "Effects of Fiscal Stimulus in Structural Models," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(1), pages 22-68, January.
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    Cited by:

    1. A. Berthou. & G. Gaulier., 2013. "Wage dynamics and current account rebalancing in the euro area," Quarterly selection of articles - Bulletin de la Banque de France, Banque de France, issue 30, pages 71-91, Summer.
    2. Zsolt Darvas, 2013. "The Euro Area's Tightrope Walk: Debt and Competitiveness in Italy and Spain," Working Papers 1307, Department of Mathematical Economics and Economic Analysis, Corvinus University of Budapest.
    3. Gunther Schnabl & Timo Wollmershäuser, 2013. "Fiscal Divergence and Current Account Imbalances in Europe," CESifo Working Paper Series 4108, CESifo Group Munich.
    4. Zsolt Darvas, 2012. "Intra-euro rebalancing is inevitable but insufficient," Policy Contributions 747, Bruegel.
    5. Zsolt Darvas, 2012. "The euro crisis: ten roots, but fewer solutions," Policy Contributions 755, Bruegel.
    6. Ferrán Brunet, 2013. "Convergence and Divergences in the European Economy: Rebalancing and Being Competitive in a Non-optimal Monetary Union," Working Papers 03/13, Instituto Universitario de Análisis Económico y Social.

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