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 …show more content…
The new exchange rate level would depend on a number of factors such as the relative size of both countries and their sensitivity to changes in the real exchange rate. This level could be appropriate on average, but would still result in excess supply in country 1 (as shown by the distance Y to Y’) and excess demand in country 2 (as shown by the distance Z to Z’), therefore causing both countries to be in disequilibrium. It is evident that for asymmetric shocks in a monetary union, central bank exchange rate manipulations that benefits one country, costs the other. Whilst the actions of a free floating exchange rate will result in both countries being in
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 …show more content…
The new exchange rate level would depend on a number of factors such as the relative size of both countries and their sensitivity to changes in the real exchange rate. This level could be appropriate on average, but would still result in excess supply in country 1 (as shown by the distance Y to Y’) and excess demand in country 2 (as shown by the distance Z to Z’), therefore causing both countries to be in disequilibrium. It is evident that for asymmetric shocks in a monetary union, central bank exchange rate manipulations that benefits one country, costs the other. Whilst the actions of a free floating exchange rate will result in both countries being in