The E¤ect of European Monetary Integration on Macroeconomic Theory

The fundamental economic paradigms of our time are not being rewritten as a result of the emergence of European monetary union. Rather, it was a revolution in economic theory that helped make possible the creation of a European common currency. In the 1960s it was believed that there is a long-run tradeo¤ between in‡ation and unemployment and output; society can choose to have a higher level of economic activity if it is willing to tolerate the higher in‡ation. This view suggests that deciding upon monetary policy is a political activity, involving a weighing of the bene…ts to one group againsts the costs to another. By the end of the 1960s the belief in this stable Phillip’s curve relationship between in‡ation and unemployment had waned. Edmumd Phelps [28] and Milton Friedman [18] argued that, although monetary policy can have a signi…cant temporary e¤ect on the economy, it has little long-run e¤ect on employment and output. Following the rational expectations revolution in the 1970s, the prevailing belief among academics became that, instead of an exploitable Phillip’s curve tradeo¤ between price stability and real economic activity, there is a positive relationship between unexpected in‡ation and employment and output. This implies that, at most, monetary policy can smooth business cycle ‡uctuations if it has an informational advantage over the private sector. Milton Friedman and the monetarist school questioned even a stabilisation role for monetary policy, claiming that there are long, variable and uncertain lags between the implementation of monetary policy and when its e¤ects are realised. During the 1970s and the early 1980s many economists came to believe that, not only is stabilising the economy di¢ cult, it also has the drawback that activist central banks may be inclined to in‡ate too much. The in‡ation bias arises because policy makers are tempted to exploit the relationship between unexpected in‡ation and real activity by in‡ating more than the public anticipates. However, the public understands that a policy maker has this incentive and