Strategic monetary policy in a monetary union with non-atomistic wage setters

4 Inflation-employment trade-off

This section explains how a move from a NMP regime, i.e. a setup where each country has
its own CB setting the money supply, to a MU with a common CB may affect the trade-off
between inflation and employment for the CB. Henceforth we base the comparison on the
results obtained under a NMP regime in Cuciniello (2007).

In setting her optimal monetary policy the CB faces a trade-off between inflation and
employment. Since all firms have the same reaction function, from cost minimization we
achieve the following aggregate demand for labor

1     1„ ∖ ^a

L_c = (Y_c) “ = Ç-¹ j , c ∈ [H, F]                      (23)

where the second equality stems from equation (13) and (14). Then taking logs and
plugging equation (20) into equation (23) yields

lc ≡ log Lc = m. - ω_c.                             (24)

Now the MU Phillips curve is obtained by solving for money supply equation (24) and
substituting it into (22),

π^u = (1 - _a)l^u + ω_u                            (25)

where l^u ≡ 7⅛ +(1 — 7)lp. The slope of the Phillips curve in the MU is hence

d~^ιu

"_dlU^ = 1 — «   0.                                   (26)

It can be shown¹⁶ that under a NMP regime the slope of the Home Phillips curve is given
^by^,

d"^N           _n

= 1 — «7 > 0.                             (27)

aι∏

It is apparent that the slope of the Phillips curve depends on the monetary regime set
up in the country as the following proposition summarizes.

Proposition 1 The formation of a MU leads a change in the trade-off between inflation
and employment faced by the CB so that the Phillips curve is flatter in the MU, ^fff^ > ^fff^-.

Intuitively, the impact of money supply on aggregate employment is always equal to
one (see equation (24)). Conversely, the general level of price is affected differently by the
CB in a MU and under a NMP. Under floating exchange rates, the Home CB influences
the CPI via the producer price index and the nominal exchange rate. In a MU this second
channel is ruled out. The Proposition 1 simply states that the two channels of transmission

¹⁶See Cuciniello (2007).

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