Abstract
The recent economic woes of some Eurozone countries have raised doubts about whether they can remain in the Eurozone. Prior to these problems emerging, the price levels in these countries rose faster than the average Eurozone price level and their rates of economic growth were higher. It is conjectured in this paper that the two sets of events are connected. Using a formal theory of inflation in the Eurozone based on a stylised version of the New Keynesian model, it is shown that, due to a “one-size-fits-all” monetary policy, inflation rates in individual Eurozone countries are unlikely to converge, and their price levels are likely to diverge, causing large differences in levels of competitiveness over time. The reason for this is different real effects in these economies such as productivity differences or different fiscal policies. In other words the Eurozone is not an optimal currency area. Despite the outstanding record of the ECB in achieving its inflation goals, it is powerless to affect the underlying problem.
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