Monetary Interaction between Europe and America: Case C

Abstract

This chapter deals with case C. The European central bank has a single target, that is zero inflation in Europe. By contrast, the American central bank has two conflicting targets, that is zero inflation and zero unemployment in America. The model of unemployment and inflation can be represented by a system of four equations:

$$ u_{1} = A_{1}- M_{1} + 0.5M_{2} $$

(1)

$$ u_{2} = A_{2}- M_{2} + 0.5M_{1} $$

(2)

$$ \pi_{1} = B_{1}+M_{1}-0.5M_{2} $$

(3)

$$ \pi_{2} = B_{2}+M_{2}-0.5M_{1} $$

(4)

The target of the European central bank is zero inflation in Europe. The instrument of the European central bank is European money supply. By equation (3), the reaction function of the European central bank is:

$$2{\rm M}_1 = - 2{\rm B}_1 + {\rm M}_2$$

(5)

Suppose the American central bank lowers American money supply. Then, as a response, the European central bank lowers European money supply.