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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
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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
