DP1846 | Bankers' Versus Workers' Europe (I): Adverse Selection in EMU

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The delegation of monetary policy to a supranational Central Bank creates a conflict of interest between residents of different countries. For example, the country in recession favours more inflation to boost output, while the country in boom prefers exactly the opposite. This conflict gives rise to an adverse selection problem. Provided each government has private information about the current state of the economy, it may try to exploit it in order to shift the common monetary policy to his own preferred way. The paper shows that problems of this kind can generate both an inflation and primary deficit bias (in line with the worries of Workers? Europe addressed by the ?stability pact?) and an excess monetary discipline and recession bias (in line with the worries addressed by the Bankers? Europe concern). When information problems are particularly severe, monetary policy becomes relatively insensitive to business cycle conditions, and too little ?smoothing? is done by monetary (and fiscal) policy. Inflation oscillates between periods of severe contractions (stop) and periods of extreme expansions (go), amplifying the business cycle .