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Reviewing adjustment dynamics in EMU: from overheating to overcooling

  • Servaas Deroose
  • Sven Langedijk
  • Werner Roeger

This paper analyses how adjustment dynamics, in an environment with some degree of price and wage rigidity, may create and strengthen asymmetric developments in a monetary union. It presents a simple illustrative model of adjustment dynamics that reproduces quite nicely actual developments in the first years of EMU. The model is used to analyse adjustments to two types of shocksrelative competitiveness shifts and demand disturbances. It is shown that the interaction between real exchange rate adjustment and real interest rate developments may contribute to periods of overheating and overcooling during which output might be for a number of years either above or below potential.Furthermore, the paper looks at the circumstances in which smooth adjustment to shocks can be expected and, on the other hand, when a cycle with greater amplitude is more likely. Finally, the paper examines policy options that could improve the functioning of EMU. The analysis provides another strong argument for pressing ahead with reforms that increase flexibility in labour and product markets and further integrate the economies of the euro area.

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Paper provided by Directorate General Economic and Financial Affairs (DG ECFIN), European Commission in its series European Economy - Economic Papers with number 198.

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Length: 33 pages
Date of creation: Jan 2004
Date of revision:
Handle: RePEc:euf:ecopap:0198
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  14. Patrick Honohan & Brendan Walsh, 2002. "Catching Up with the Leaders: The Irish Hare," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 33(1), pages 1-78.
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  16. Steinar Holden, 2002. "The Costs of Price Stability - Downward Nominal Wage Rigidity in Europe," NBER Working Papers 8865, National Bureau of Economic Research, Inc.
  17. Michael Reutter & Hans-Werner Sinn, 2000. "The Minimum Inflation Rate for Euroland," CESifo Working Paper Series 377, CESifo Group Munich.
  18. Mongelli, Francesco Paolo, 2002. ""New" views on the optimum currency area theory: what is EMU telling us?," Working Paper Series 0138, European Central Bank.
  19. Jan Hansen & Werner Roeger, 2000. "Estimation of real equilibrium exchange rates," European Economy - Economic Papers 144, Directorate General Economic and Financial Affairs (DG ECFIN), European Commission.
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