The 'Uncovered Inflation Rate Parity' Condition in a Monetary Union

Acocella N. and Pasimeni P. (2018) "The Uncovered Inflation Rate Parity Condition in Monetary Union". Forum for Macroeconomics and Macroeconomic Policies Working Papers, Nr.28. IMK 2018, ISSN: 2512-8655. https://ideas.repec.org/p/imk/fmmpap/28-2018.html

24 Pages Posted: 7 Aug 2018 Last revised: 22 Nov 2020

See all articles by Nicola Acocella

Nicola Acocella

University of Rome I - Department of Methods and Models for Economics, Territory and Finance (MEMOTEF)

Paolo Pasimeni

European Commission; IES-VUB

Date Written: June 29, 2018

Abstract

The uncovered interest rate parity condition lies at the heart of the "impossible trinity", stating that the three objectives of fixed exchange rates, free capital flows, and independent monetary policy cannot be pursued simultaneously. We argue that although monetary unification does indeed eliminate the tension between exchange rates and nominal interest rates, it does not solve the problem of the intrinsic instability of the system. By eliminating the intra-area exchange rates (with a single currency) and interest rate differentials (with a single common policy rate set by the common central bank), the problem of instability is simply transferred to inflation rate differentials, what we call the (impossibility of the) "uncovered inflation rate parity condition" in a monetary union. The analysis of the actual divergences and imbalances in the EMU, then, suggests that failure to respect the "uncovered inflation rate parity condition" in a monetary union may lead to increasing economic and political tensions. Thus we conclude with the application of the Rodrik's political trilemma to the EMU, which epitomises the existential challenges that the EU faces nowadays.

Keywords: Monetary Union, interest rate, exchange rate, inflation differentials, political trilemma

JEL Classification: E42, F33, F41, F42

Suggested Citation

Acocella, Nicola and Pasimeni, Paolo, The 'Uncovered Inflation Rate Parity' Condition in a Monetary Union (June 29, 2018). Acocella N. and Pasimeni P. (2018) "The Uncovered Inflation Rate Parity Condition in Monetary Union". Forum for Macroeconomics and Macroeconomic Policies Working Papers, Nr.28. IMK 2018, ISSN: 2512-8655. https://ideas.repec.org/p/imk/fmmpap/28-2018.html , Available at SSRN: https://ssrn.com/abstract=3216406 or http://dx.doi.org/10.2139/ssrn.3216406

Nicola Acocella

University of Rome I - Department of Methods and Models for Economics, Territory and Finance (MEMOTEF) ( email )

Via del Castro Laurenziano 9
Roma, Roma 00161
Italy
+390649766359 (Phone)

HOME PAGE: http://www.memotef.uniroma1.it/newdip/utenti/acocellanicola/

Paolo Pasimeni (Contact Author)

European Commission ( email )

Rue de la Loi 200
Brussels, B-1049
Belgium

IES-VUB ( email )

Pleinlaan, 5
Brussels, 1050
Belgium

HOME PAGE: http://https://www.ies.be/users/paolo-pasimeni

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