Reviewing Adjustment Dynamics in EMU: From Overheating to Overcooling

European Economy Economic Paper No. 198

35 Pages Posted: 10 Nov 2009

See all articles by Servaas Deroose

Servaas Deroose

European Commission

Werner Roeger

European Commission, DGECFIN; European Commission

Sven Langedijk

European Union - European Commission; Joint Research Center of the European Commission

Date Written: October 18, 2008

Abstract

This paper analyses how adjustment dynamics, in an environment with some degree of price and wage rigidity, may create and strengthen asymmetric developments in a monetary union. It presents a simple illustrative model of adjustment dynamics that reproduces quite nicely actual developments in the first years of EMU. The model is used to analyse adjustments to two types of shocks - relative competitiveness shifts and demand disturbances. It is shown that the interaction between real exchange rate adjustment and real interest rate developments may contribute to periods of overheating and overcooling during which output might be for a number of years either above or below potential. Furthermore, the paper looks at the circumstances in which smooth adjustment to shocks can be expected and, on the other hand, when a cycle with greater amplitude is more likely. Finally, the paper examines policy options that could improve the functioning of EMU. The analysis provides another strong argument for pressing ahead with reforms that increase flexibility in labour and product markets and further integrate the economies of the euro area.

Keywords: overheating, overcooling, current account, imbalance, euro area, adjustment, inflation, competitiveness, EMU, real exchange rate, real interest rate

JEL Classification: A1, A10

Suggested Citation

Deroose, Servaas and Roeger, Werner and Roeger, Werner and Langedijk, Sven, Reviewing Adjustment Dynamics in EMU: From Overheating to Overcooling (October 18, 2008). European Economy Economic Paper No. 198, Available at SSRN: https://ssrn.com/abstract=1286422 or http://dx.doi.org/10.2139/ssrn.1286422

Servaas Deroose

European Commission ( email )

Office BU1 0/201
B-1049 Brussels
Belgium
+32 2 299 4375 (Phone)
+32 2 299 3505 (Fax)

Werner Roeger

European Commission, DGECFIN ( email )

Economic and Financial Affairs
BU1-3/159, 200 Rue de la Loi
B-1049 Brussels
Belgium

European Commission ( email )

Economic and Financial Affairs
BU1-3/159, 200 Rue de la Loi
B-1049 Brussels
Belgium

Sven Langedijk (Contact Author)

European Union - European Commission ( email )

Rue de la Loi 200
Brussels, B-1049
Belgium

Joint Research Center of the European Commission ( email )

Via E. Fermi 2749
1049
Belgium

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