DP6337 | Is the Euro Sustainable?

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15/06/2007

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Abstract

It is widely recognised that the "one-size-fits-all" monetary policy of the euro-zone is a potential problem. How much of a problem has not been much investigated. It is argued in this paper that it may result in the euro not being sustainable in the longer term without drastic changes to other aspects of the EU and, in particular, to fiscal policy. The problem is not the fault of the ECB, but is due to having a single nominal interest rate. As a result, the evidence reveals that national price levels are diverging over time which is leading to a permanent and unsustainable loss of competitiveness. A formal theory of inflation in the euro-zone based on an open-economy version of the New Keynesian model is used to analyse the problem. Although the euro system has automatic stabilising mechanisms arising from the changes in competitiveness and from absorbtion effects, these are shown to be not strong enough. The model is then modified to allow for fiscal transfers between countries and the size of the transfers required to produce a euro that may be sustainable are derived. It is shown that, in effect, this is an inflation tax, requiring high inflation countries to make transfers to low inflation countries as often happens within a single country in the form of unemployed benefits to low activity regions. Ultimately, the choice may lie between closer political union and a break-up of the euro-zone.