The Effect Of An Asymmetric Shock On A Monetary Union Essay

702 Words Nov 29th, 2014 3 Pages
In order to analyse the effect of an asymmetric shock on a monetary union, I have constructed figure 1. For the sake of coherence and simplicity, this illustrates a two country monetary union; and will be analysed under the key assumption that both prices and wages are sticky . The vertical axis in both diagrams measures each respective country’s real exchange rate in relation to the rest of countries in the world : 〖EP〗^1/P^* and 〖EP〗^2/P^*. E is the common currency’s exchange rate, which is initially E_0. Point W shows the initial situation where the real exchange rate in both countries is the same, λ_0, and λ_0=E_0 P^1/P^*=E_0 P^2/P^*.

For the purpose of analysis, it is assumed that country 1 exclusively suffers an adverse shock due to the worlds demand for its exports plummeting as a result of changing consumer tastes. This shock is illustrated in diagram 1 through a leftward shift in aggregate demand (AD) from AD to AD’. In a monetary union, both countries have a common nominal exchange rate and the common central bank may need to make a choice. If the central bank is more favourable towards country 1, it would depreciate the common exchange rate to E_1, and sticky prices would result in both countries having the same real exchange rate, λ_1. For country 1, this effectively makes their exports cheaper and more attractive to foreign consumers, essentially reducing further possible output decline, by the distance of (W’ to X), compared to if the exchange rate remained…

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