Inflation and Unemployment in a Monetary Union PDF
Preview Inflation and Unemployment in a Monetary Union
Michael Carlberg IInnffllaattiioonn aanndd UUnneemmppllooyymmeenntt iinn aa MMoonneettaarryy UUnniioonn 1 23 Inflation and Unemployment in a Monetary Union Michael Carlberg Inflation and Unemployment in a Monetary Union Professor Dr. Michael Carlberg Helmut Schmidt University Hamburg Federal University of Hamburg Holstenhofweg 85 22043 Hamburg Germany [email protected] ISBN 978-3-540-79300-7 e-ISBN 978-3-540-79301-4 Library of Congress Control Number: 2008928778 © 2008 Springer-Verlag Berlin Heidelberg This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permissions for use must always be obtained from Springer-Verlag. Violations are liable for prosecution under the German Copyright Law. The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Cover design: WMXDesign GmbH, Heidelberg, Germany Printed on acid-free paper 9 8 7 6 5 4 3 2 1 springer.com Preface This book studies the coexistence of inflation and unemployment in a monetary union. The focus is on how to reduce the associated loss. The primary target of the European central bank is low inflation in Europe. The primary target of the German government is low unemployment in Germany. And the primary target of the French government is low unemployment in France. The European central bank has a quadratic loss function. The same applies to the German government and the French government. The key questions are: To what extent can the sequential process of monetary and fiscal decisions reduce the loss caused by inflation and unemployment? Is monetary and fiscal cooperation superior to the sequential process of monetary and fiscal decisions? The present book is part of a larger research project on European Monetary Union, see the references given at the back of the book. Some parts of this project were presented at the World Congress of the International Economic Association, at the International Conference on Macroeconomic Analysis, at the International Institute of Public Finance, and at the International Atlantic Economic Conference. Other parts were presented at the Macro Study Group of the German Economic Association, at the Annual Meeting of the Austrian Economic Association, at the Göttingen Workshop on International Economics, at the Halle Workshop on Monetary Economics, at the Research Seminar on Macroeconomics in Freiburg, at the Research Seminar on Economics in Kassel, and at the Passau Workshop on International Economics. Over the years, in working on this project, I have benefited from comments by Iain Begg, Michael Bräuninger, Volker Clausen, Valeria de Bonis, Peter Flaschel, Helmut Frisch, Wilfried Fuhrmann, Franz X. Hof, Florence Huart, Oliver Landmann, Jay H. Levin, Alfred Maußner, Jochen Michaelis, Reinhard Neck, Manfred J. M. Neumann, Klaus Neusser, Franco Reither, Armin Rohde, VI Preface Sergio Rossi, Gerhard Rübel, Michael Schmid, Gerhard Schwödiauer, Egbert Sturm, Patrizio Tirelli, Harald Uhlig, Bas van Aarle, Uwe Vollmer, Jürgen von Hagen and Helmut Wagner. In addition, Christian Gäckle, Arne Hansen and Mirko Hoppe carefully discussed with me all parts of the manuscript. Last but not least, Christine Bergner and Doris Ehrich did the secretarial work as carefully as ever. I would like to thank all of them. Michael Carlberg Executive Summary 1) Monetary policy in Europe. For ease of exposition we assume that the monetary union consists of two countries, say Germany and France. An increase in European money supply lowers unemployment in Germany and France. On the other hand, it raises inflation there. The targets of the European central bank are low inflation and low unemployment in Europe. As a result, monetary policy in Europe can reduce the loss caused by inflation and unemployment. 2) Fiscal policies in Germany and France. Take for instance fiscal policy in Germany. An increase in German government purchases lowers unemployment in Germany. On the other hand, it raises inflation there. The targets of the German government are low unemployment and low inflation in Germany. As a result, fiscal policy in Germany can reduce the loss caused by unemployment and inflation. 3) The central bank and the governments decide sequentially. First the central bank decides, then the governments decide. As a result, the sequential process of monetary and fiscal decisions can reduce the loss caused by inflation and unemployment. 4) Comparing sequential decisions with pure monetary policy. As a result, pure monetary policy can reduce the loss caused by inflation and unemployment to a certain extent. By contrast, the sequential process of monetary and fiscal decisions can reduce the loss to a larger extent. Judging from this point of view, the sequential process of monetary and fiscal decisions seems to be superior to pure monetary policy. 5) Comparing sequential decisions with pure fiscal policies. As a result, pure fiscal policies can reduce the loss caused by unemployment and inflation to a certain extent. The sequential process of monetary and fiscal decisions can reduce the loss to the same extent. Pure fiscal policies cause an increase in the European budget deficit. By contrast, the sequential process of monetary and fiscal decisions causes a decline in the European budget deficit. Judging from VIII Executive Summary this perspective, the sequential process of monetary and fiscal decisions seems to be superior to pure fiscal policies. 6) The central bank and the governments cooperate. The targets of policy cooperation are low inflation and low unemployment in each of the countries. As a result, monetary and fiscal cooperation can reduce the loss caused by inflation and unemployment. 7) Comparing policy cooperation with sequential decisions. As a result, under each system, the loss is reduced to the same extent. Sequential decisions are a slow process consisting of four steps. By contrast, policy cooperation is a fast process consisting of only two steps. Sequential decisions cause some overshooting in unemployment and inflation. By contrast, policy cooperation does not cause any overshooting in unemployment and inflation. Judging from this point of view, policy cooperation seems to be superior to sequential decisions. Contents in Brief Introduction.....................................................................................................1 Part One. The Rate of Inflation..............................................................9 Chapter 1. Monetary Policy in Europe.................................................................11 Chapter 2. Fiscal Policies in Germany and France...............................................19 Chapter 3. Central Bank and Governments Decide Sequentially.........................25 Chapter 4. Central Bank and Governments Cooperate.........................................32 Chapter 5. The Countries Differ in Size...............................................................37 Chapter 6. The Countries Differ in Behaviour.....................................................41 Chapter 7. The Monetary Union of Three Countries............................................45 Part Two. The Rate of Unemployment..............................................49 Chapter 1. Monetary Policy in Europe.................................................................51 Chapter 2. Fiscal Policies in Germany and France...............................................59 Chapter 3. Central Bank and Governments Decide Sequentially.........................65 Chapter 4. Central Bank and Governments Cooperate.........................................72 Chapter 5. The Countries Differ in Size...............................................................77 Chapter 6. The Countries Differ in Behaviour.....................................................81 Chapter 7. The Monetary Union of Three Countries............................................85 Part Three. Inflation and Unemployment: The Monetary Union as a Whole................................89 Chapter 1. The Model...........................................................................................91 Chapter 2. Some Numerical Examples.................................................................98 Chapter 3. Monetary Policy in the Phillips Curve Diagram...............................109 X Contents in Brief Part Four. Inflation and Unemployment: The Monetary Union of Two Countries..................113 Chapter 1. Monetary Policy in Europe...............................................................115 Chapter 2. Fiscal Policies in Germany and France.............................................127 Chapter 3. Central Bank and Governments Decide Sequentially.......................137 Chapter 4. Central Bank and Governments Cooperate.......................................151 Chapter 5. Central Bank and Governments Differ in Loss Function.................166 Appendix........................................................................................................175 Conclusion.....................................................................................................197 Result...............................................................................................................217 Symbols..........................................................................................................223 The Current Research Project............................................................225 References.....................................................................................................229 Index................................................................................................................241
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