Wednesday, December 14, 2011

...The implications for Eurozone Policy

So here are the implications for the Eurzone situation. As the central bank for the Eurozone, the ECB is in charge of shifting the LM curve so as to reach the IS-LM-FE equilibrium. But now the problem may become apparent to the astute reader. The problem with multiple economies sharing one central bank is that each economy has its own FE curve, its own IS curve, but is expected to share ONE LM curve. And the ECB has happily altered the nominal supply of euros so as to hit an M/P that corresponds to an LM that is at the IS-FE point for Germany. So Germany has recovered from the slump and is enjoying 5.8% unemployment with stable prices. But the LM curve that is at IS-LM-FE for Germany corresponds to an IS-LM that is to the left of FE for Spain. To the left of FE for Italy. To the left of FE for Ireland. (I wish I could create my own damn graphs for this; it would be more clear. Maybe someday.)

Remember before when I said that if IS-LM was to the left of IS-FE, deflation could increase the real money supply (M/P) so as to shift the LM curve to the right? Well that is exactly the solution ECB and German officials have proposed for the periphery countires (they call it "internal devaluation," a term I kind of like). That is fine in principle: if Italian and Spanish and Irish workers would agree to lower nominal wages and firms would slash nominal prices, the real money supplies in those countries would expand; their markets could create their own "monetary expansion" without the ECB creating more nominal money balances.

But the problem here is not theoretical: its practical. Economists since the 1930s have made the observation that in practice, firms are very reluctant to cut nominal prices and workers are very reluctant to accept nominal wage reductions. This is partially explained by the idea that firms and workers have a hard time distinguishing between nominal reductions and real reductions; whatever the reason, the price level is considered "sticky" in the short run. That is why monetary policy that expands the nominal stock of money (the M in M/P) is relied on to shift the LM curve and not reductions in P. So while in theory the periphery should be able to deflate its way to full employment, the reality is that doing so will take an intolerably long time, if it can even be fully achieved.

Plus, there's the issue of debt-deflation...

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