Exchange rates and the European business cycle: An application of a quasi-empirical two-country model

Abstract

A quasi-empirical symmetric two-country model is used to analyse the case in which country A, as an anchor country, pursues price stability as its main priority, whereas country B stresses exchange rate stability. Problems will arise, in particular for the latter country, when in country A contractionary tax and monetary policy measures are taken after expansionary wage impulses have occurred. In addition, the analysis should shed light upon the recent problems of a European stagnation within an unstable European Monetary System. The model, presented as an exempli gratia in order to promote quasi-empirical modelling, integrates the q theory of investment with the approach of a portfolio choice in which both domestic and foreign agents spread their non-human wealth over imperfectly substitutable domestic and foreign share capital, domestic and foreign government bonds, domestic and foreign treasury bills, domestic and foreign time deposits and domestic and foreign money. Within the framework of fixed or floating exchange rates, rigid labour markets, sticky price and/or flexible price regimes in the goods markets, due account is taken of capital accumulation, government debt and current account dynamics. The analysis shows why politicians have fundamental reasons to question the usefulness of a European Monetary Union within a framework of fixed exchange rates. The pros of the latter system are probably outweighed by the cons.