Divergent business cycles as an effect of a monetary union

Abstract

After 10 years of the euro it is well documented that the paths and rates of growth differ among the countries of the zone. In particular, some countries experience a kind of a business cycle characterized with an economic slowdown or recession after a period of strong demand and overheating. This paper offers a theoretical explanation of these phenomena. I claim that nominal and real divergences in a monetary union are endogenous dynamics and not necessarily a result of any asymmetrical shocks. The paper develops micro-based, rational expectations model that presents inflation differentials, current account deficits and eventually ratcheting the economy down as an effect of joining a monetary union or–more specifically–of restrictions which a common currency puts on interest rates and exchange rate flexibility. Within this theoretical framework the results of economic policy in a monetary union may be suboptimal; the domestic product ends up below its potential level that the economy could attain at a flexible exchange rate and an individually set interest rate. This solution is an example of Nash equilibrium which is not Pareto optimal. It proves again that micro-optimization is not a substitute for a proper macroeconomic policy that should create the right conditions for decisions taken by individual agents. When representative agents differ among countries with respect to their inter-temporal preferences macro-policies should be “customized”, one size does not fit all. As a bonus, the conclusions of the paper also find an easy application to the business cycles typical for exchange rate based inflation stabilization programmes, an issue once extensively discussed in the literature. These cycles receive in the paper a coherent theoretical explanation with the same rationale that stands behind the description of nominal and real divergences in a monetary union.