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Monetary Policy in a Non-optimal Currency Union: Lessons for the European Central Bank

This paper examines how monetary policy should be conducted in a non-optimal currency area, and argues that optimal policy requires a slightly higher rate of equilibrium inflation to avoid higher unemployment. Formation of a non-optimal currency area shifts the Phillips curve to the right, and worsens the inflation - unemployment trade-off. This has important implications for the ECB, since it is widely agreed that the euro area is not an optimum currency area. By carrying over the old Bundesbank’s implicit two percent inflation target, the ECB is setting policy as if the euro were an optimum currency area. The euro area therefore stands to have higher unemployment. Lastly, the analysis in the paper has important implications for plans to enlarge the euro area. To the extent that enlargement worsens the non-optimality of the euro area, it further worsens the ECB’s inflation - unemployment trade-off. Preventing unemployment from rising will require an even higher inflation target.