Thursday, December 6, 2007

Optimal Currency Areas, or the Costs of a Single Currency

. Thursday, December 6, 2007

The European Central Bank is confronting its first policy challenge. Caught between sagging growth and rising prices, the ECB today kept interest rates steady. Of particular interest is the ECB's fear that rising prices will feed into large nominal wage increases that will in turn exert additional inflationary pressures.

Pre-EMU, wage bargaining in many countries was structured by the interaction between corporatist labor markets and independent central banks. In this context, the independent central bank signalled a commitment to low inflation and unions set their wage demands based on this signal. All of this worked because wage bargaining was highly centralized, and thus unions had an incentive to internalize the short-run trade off between wages and employment.

Wage bargaining is much more decentralized under EMU, and consequently unions have less incentive to practice wage moderation. The ECB has thus become worried that rising inflation "could be amplified by so-called second-round effects, like demands by unions for hefty wage increases." Earlier in the week, ECB president, Jean-Claude Trichet sharply criticized the German government's imposition of a minimum wage for postal workers that, in many cases, is far more that what they were previously being paid."

'We will not tolerate second-round effects,' Trichet said during a news conference in Frankfurt, implying that the bank would raise rates if it saw such activity."

This suggests that ECB policy is being driven by the desire to build anti-inflation credibility and that the ECB seems willing to risk a recession to earn this reputation.

Across the Channel, the Bank of England leaned the other way. "Higher prices for food and fuel have also nudged inflation in Britain above the 2 percent target set by the Bank of England. But that bank's monetary policy committee said the threat of inflation was overshadowed by the dampening effects of continued turmoil in the credit markets."

Anybody still wonder why the UK opted out of EMU?

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Optimal Currency Areas, or the Costs of a Single Currency
 
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