A Macroeconomic Framework for Euroland

Inflation differentials among EMU members ‘should not be demonised…[they] are the mechanism for adjusting real exchange rates, when adjustment is needed’. Thus the Irish economy should be slowed by the rising price of Irish goods, not by a tightening of the budget: this is contrary to the advice that has been given by the European Commission and Ecofin to the Dublin government. Five leading economists have come to this controversial conclusion in the latest report in the Monitoring the European Central Bank series, published by the Centre for Economic Policy Research.

Monetary policy in Euroland is set by one central bank, fiscal policy by twelve governments. If both sides do their job properly, there is no need for explicit coordination. If the fiscal authorities run an imprudent policy, ‘then explicit coordination may even be counterproductive’. Formal meetings between finance ministers and the monetary authority could all too easily become an occasion for pressuring the European Central Bank. Meetings are of course useful for exchanging information, but they should be kept strictly informal. A consequence is that the Nice treaty provisions for Enhanced Cooperation should not be applied to the Eurogroup in order to turn it into a formal institution.

The economists also applaud the ECB decision to publish projections for inflation. This was an important first step, but the Bank should move one step forward and produce interest rate forecasts, rather than inflation projections based on the assumption that interest rates will remain unchanged. The current exercise shows a lot of uncertainty regarding the future path of inflation, and no uncertainty regarding interest rates: reality will of course be quite the opposite.

The report also sets out a clear exposition of the nature of inflation targeting. This monetary policy strategy ‘is often misunderstood as being either an arcane, technical aspect of central banking or an extreme form of “monetarism”’. Both views are wrong. ‘Inflation targeting is, in essence, a way of setting monetary policy so as to keep output close to potential, wherever potential output happens to be, while keeping inflation close to its target.’ The report says that the ECB should abandon its ‘two pillars’ and adopt simple inflation targeting. And here is a further argument against ‘coordination’. The two-pillar policy leaves the ECB some discretion, and this ‘makes coordination even less desirable, since the fiscal authorities may have more “room to manoeuvre” in putting pressure on the ECB’.

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The Authors:

Alberto Alesina is Professor of Economics at Harvard University and is also a Research Fellow in CEPR’s International Macroeconomics and Public Policy research programmes. Olivier Blanchard is Professor of Economics at the Massachusetts Institute of Technology. Jordi Galí is Professor of Economics at CREI, Universitat Pompeu Fabra, Barcelona, and a Programme Director of CEPR’s International Macroeconomics research programme. Francesco Giavazzi is Professor of Economics at IGIER, Università Bocconi in Milan and is also a Research Fellow in CEPR’s International Macroeconomics research programme. Harald Uhlig is Professor of Economics at Humboldt Universität zu Berlin and is a Research Fellow in CEPR’s International Macroeconomics and Financial Economics research programmes.

The research underlying this publication was supported by
Citibank, a member of Citigroup _ MPS Finance Banca Mobiliare SpA & Gruppo Monte Paschi Asset Management SGR

Defining a Macroeconomic Framework
for the Euro Area
Monitoring the European Central Bank Volume 3: 
Alberto Alesina, Olivier Blanchard, Jordi Galí,
Francesco Giavazzi, Harald Uhlig

ISBN 1 898128 59 6    Price:  £30

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