Economics, 3rd Edition

A Shift in Consumer Preferences Away from German Goods Towards French Goods

The German fall in aggregate demand leads to a fall in output from Y

1

G

 to Y

2

G

, and a fall in the price level from P

1

G

 to P

2

G

.  

The increase in French aggregate demand raises output from Y

1

F

 to Y

2

F

. Over time, however, wages and prices will adjust, so 

that German and French output return to their natural levels, Y

1

G

 and Y

1

F

, with lower prices in Germany, at P

3

G

, and higher prices 

in France, at P

3

F

.

Aggregate

demand, 

AD

1

G

Short-run aggregate

supply, 

AS

1

G

Germany

Long-run

aggregate

supply

Long-run

aggregate

supply

Price

level

A

F

A

G

B

F

B

G

C

F

C

G

Quantity of output

AS

2

F

AD

2

F

AD

2

F

AD

2

G

AS

1

F

AS

2

G

P

1

F

Y

1

F

P

2

F

Y

2

F

Y

1

G

Y

2

G

P

3

F

P

1

G

P

2

G

P

3

G

AD

1

F

Price

level

France

Quantity of output

A Shift i C

FIGURE 36.1

Note that, if Germany and France had maintained their own currencies and a flexible foreign exchange 

rate, then the short-term fluctuations in aggregate demand would be alleviated by a movement in the 

exchange rate: as the demand for French goods rises and for German goods falls, this would increase 

the demand for French francs and depress the demand for German marks, making the value of francs 

rise in terms of marks in the foreign currency exchange market. This would make French goods more 

expensive to German residents since they now have to pay more marks for a given number of French 

francs.  Similarly, German goods become less expensive to French residents. Therefore, French net exports 

would fall, leading to a fall in aggregate demand. This is shown in Figure 36.2, where the French aggregate 

demand schedule shifts back to the left until equilibrium is again established at the natural rate of output. 

Conversely – and also shown in Figure 36.2 – German net exports rise and the German aggregate demand 

schedule shifts to the right until equilibrium is again achieved in Germany.

In a currency union, however, this automatic adjustment mechanism is not available, since, of course, 

France and Germany have the same currency (the euro). The best that can be done is to wait for wages 

and prices to adjust in France and Germany so that the aggregate supply shifts in each country, as in 

Figure 36.1. The resulting fluctuations in output and unemployment in each country will tend to create 

tensions within the monetary union, as unemployment rises in Germany and inflation rises in France. 

German policymakers, dismayed at the rise in unemployment, will favour a cut in interest rates in order to 

boost aggregate demand in their country, while their French counterparts, worried about rising inflation, 

will be calling for an increase in interest rates in order to curtail French aggregate demand. The ECB will 

not be able to keep both countries happy. Most likely, it will set interest rates higher than the German 

desired level and lower than the French desired level. The ECB pursues an inflation targeting strategy, and 

the inflation rate it targets is based upon a consumer prices index constructed as an average across the 

euro area. If a country’s inflation rate (or expected inflation rate) is below the euro area average, the ECB’s 

monetary policy will be too tight for that country; if it is above the average, the ECB’s monetary policy will 

---

CHAPTER 36  COMMON CURRENCY AREAS AND EUROPEAN MONETARY UNION  765

be too loose for it. All that is possible is a ‘one size fits all’ monetary policy. It is for this reason that entry 

to the eurozone is restricted to those countries that can meet the criteria outlined above where inflation 

and interest rates are close to the EU average.