The Maastricht Treaty approaches the issue of monetary union in nominal terms with inflation, interest rates, and deficit and debt ratios the key points of concern. Nominal convergence has been rigorously pursued, but at the expense of the real sector. As a result, the real sector must absorb all of the costs of country-specific differences which emerge when a single regime is imposed on heterogeneous economies. In Discussion Paper No. 1189, Maria Demertzis and Research Fellow Andrew Hughes Hallett define the magnitude of the costs imposed on European inflation and unemployment as a result of allowing national nominal sectors to converge to the detriment of the real economy.

The authors approach the issue by estimating a Europe-wide trade-off between inflation and unemployment and then decomposing it to show the impact of the dispersion among rates of unemployment in different countries. This they call the aggregation hypothesis, within which the higher moments of the unemployment distribution are supposed to capture the degree of heterogeneity between the country members of the Union in real terms, and hence quantify the scale of the inefficiency imposed on Europe as a result of labour immobility and inflexible relative wages. They also examine the possibility of Germany adopting a hegemonic role in the wage formation process, and investigate which of the two alternative hypotheses – wage transfer or locational competition – holds in European markets. They discover that the distribution of unemployment rates and Germany's leadership role impose a great cost on the real side. Germany and Spain are the two countries that contribute the largest costs since they represent the two opposite extremes of the unemployment distribution. Overall, the process of integration renders all countries more susceptible to outside influences, suggesting that the degree of their labour markets' dissimilarity will delay the equalization of price changes and hence the adoption of a single currency.

On Measuring the Costs of Labour Immobility and Market Heterogeneity in Europe
Maria Demertzis and Andrew J Hughes Hallett

Discussion Paper No. 1189, June 1995 (HR)