For the purpose of analysis, it is assumed that country 1 exclusively suffers an adverse shock due to the worlds demand for its exports plummeting as a result of changing consumer tastes. This shock is illustrated in diagram 1 through a leftward shift in aggregate demand (AD) from AD to AD’. In a monetary union, both countries have a common nominal exchange rate and the common central bank may need to make a choice. If the …show more content…
The new exchange rate level would depend on a number of factors such as the relative size of both countries and their sensitivity to changes in the real exchange rate. This level could be appropriate on average, but would still result in excess supply in country 1 (as shown by the distance Y to Y’) and excess demand in country 2 (as shown by the distance Z to Z’), therefore causing both countries to be in disequilibrium. It is evident that for asymmetric shocks in a monetary union, central bank exchange rate manipulations that benefits one country, costs the other. Whilst the actions of a free floating exchange rate will result in both countries being in