Question

In case of an asymmetric demand shock, which "tool" cannot be used ANYMORE by countries that have joined a monetary union?

Answer 1

In the absence of nominal exchange rate flexibility vise-versa the other countries participating in a monetary union, adjustment has to occur via other channels. Many years ago, Mundell argued that if a group of countries wanted to adopt a common currency, the shocks that they were exposed to had better be similar. If that were not the case, they would need to have strong alternative adjustment mechanisms.

Mundell and others identified key conditions for such alternative adjustment mechanisms: price flexibility, factor mobility and fiscal transfers. Price flexibility is important in order to let countries affected by adverse economic shocks recover by adjusting wages and reducing relative prices in order to rebuild competitiveness. The second adjustment mechanism, cross-border factor mobility, or in particular labour mobility, helps to adjust to adverse shocks as people move out of the depressed economy until it regains competitiveness and the labour market in the country finds a new equilibrium. A third adjustment mechanism identified in the literature is fiscal transfers, flowing from the stronger countries or regions to the weaker parts of the monetary union.

Although these adjustment mechanisms are often referred to as being substitutes, they are in fact not. While the first two are important to solve the problem facing a country affected by an adverse shock, the third, fiscal transfers, only hides the problem. Temporary transfers can play a stabilising role and may be needed – subject to strict conditionality – if a country is affected by a very serious adverse shock. Open-ended transfers, however, are not a mode of adjustment. In fact, they are the opposite. They finance non-adjustment.

Therefore, the key adjustment mechanism in a monetary union is price and wage flexibility, assuming that cross-border labour mobility is limited. Wages and prices are essential for country adjustments, as they directly impact on the real exchange rate, and thus on a country’s competitiveness. In fact, wages and prices are, by definition, the only remaining component of the real exchange rate that can be adjusted in the absence of nominal exchange rate flexibility.

It is also important in this regard to distinguish between temporary and permanent adverse shocks. Options that are attractive in the face of temporary shocks may be less so if the shock is permanent or highly persistent and vice versa. In the case of a permanent adverse shock, the country in question faces an adjustment to a permanently lower standard of living.

Economic flexibility can be promoted by removing the institutional barriers to flexible wage and price-setting mechanisms. If wages and prices are flexible enough and able to adjust to changes in economic conditions, then this will not only speed up the adjustment, but it will also help to avoid unwelcome fluctuations in output and unemployment. In a monetary union, most of the adjustment has to take place through national labour markets. Therefore, wage setting should appropriately reflect the different situations of sectors, of firms and of overall labour market conditions.