between small and big countries in this regard, due to the difference in openness of their respective
economies.
Effects of a decline in structural unemployment
48. The importance of monetary policy in facilitating the adjustment of demand to a rise in supply
and for improving budget balances leads to questions about the reforms pursued by a single country in the
euro area. This is shown by a gradual decline in the structural unemployment rate by 1½ percentage points
over three years in the case a small (Belgium) and large (France) country. They are based on the same
assumption as above: the nominal interest rate and the exchange rate are fixed at the baseline level. The
results show a marked contrast between the two countries.
49. The small country, because of its much greater openness to trade, benefits much more from the
competitiveness gains, which allows a more rapid adjustment of demand and limits the deceleration in
inflation (Figure 8). The effect of the reform is positive for the budget balance, though the effect on
indebtedness is minor.
50. In contrast, the adjustment path for the large country is much more drawn-out (Figure 9). The
impact of higher real interest rates tends to neutralise the competitiveness gains due to lower inflation.
Overall, the output gap remains below the baseline level over the whole simulation period. The budget
balance hardly improves, while indebtedness is rising. However, significantly lower inflation in a large
country will affect area-wide inflation, which could lead to some monetary easing. If the interest rate were
to decline in line with overall inflation, the budget balance would improve by more.
51. These simulation results are, of course, model dependent. The weak endogenous adjustment
forces in the case of reforms of a single large euro area economy could be exaggerated. It can not be
excluded that a better macroeconomic performance, and especially lower unemployment, would lead to
substantial confidence effects, which are not included in the model. These could lead to greater dynamism
of consumption and investment. The reaction of the US economy to the productivity shock during the
1990s suggests that demand can outstrip supply, following a supply shock.7 On the other hand, one should
not underestimate either the role played by the US monetary authorities, which recognized and
accompanied the structural changes. Also the depth and flexibility of the American financial markets were
crucial in allowing a rapid transmission of the associated wealth gains onto demand.
7. This would follow Say’s law, which suggests that supply will create its demand. But the American situation even suggests what Val Koromzay
dubbed Super-Say’s law, whereby a more optimistic outlook on future income can lead to excess demand, when supply conditions improve.
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