Alesina and Grilli have applied the Rogoff framework concerning the appointment of a central banker more conservative than the median voter to argue that the diversity of individual EU countries' objectives may undermine prospects for European monetary union. In Discussion Paper No. 903, Research Fellow Paul Levine and Joseph Pearlman extend this work to develop a multi-period model of a European Central Bank (ECB) that is unable to precommit which also exhibits the nominal and real wage rigidities that characterize most European labour markets. For multi-period wage contracts, money is no longer neutral, so even anticipated inflation can have real effects.

Levine and Pearlman show that the optimum central banker is still more conservative than the median voter, and the central banker's conservatism increases with the output target (relative to the variance of each shock), wage stickiness and the conservatism of the median voter. They assess the feasibility of a monetary union, for countries whose median voters' preferences differ, by examining their welfare losses when inside and outside the union relative to the bench-mark of each country's first-best outcome of establishing its own independent central bank with a degree of conservatism appropriate to its own labour market.

Levine and Pearlman find that the existence of nominal and real wage rigidities may improve the prospects for such a union with an independent central bank outside the control of any one government, provided labour market divergences are not too great. Multi-period contracts then allow anticipated monetary policy to enhance welfare, although these benefits will not be realized unless the central bankers are able to precommit or their conservatism increases with wage rigidity. Substantial remaining differences across EU countries' labour markets concerning wage rigidities imply, however, that whether or not the ECB can achieve a degree of conservatism that benefits all members of a prospective monetary union remains an open question.

Labour Market Structure, Conservative Bankers and the Feasibility of Monetary Union
Paul Levine and Joseph Pearlman

Discussion Paper No. 903, February 1994 (IM)