A simple model of three economies with two currencies: the eurozone and the USA

This paper presents a model which describes three countries trading merchandise and financial assets with one another. It is initially assumed that all three countries have independent fiscal policies but that two of the countries share a currency — hence the model can be used to make a preliminary analysis of the conduct of economic policy in ‘the euro-zone’ vis-à-vis the rest of the world —‘the USA’. It is assumed, as seems most realistic nowadays, that the exchange rate between the eurozone and the USA is freely floating. The main conclusion will be that, if all three countries do indeed operate independent fiscal policies, the system will work under a flexible rate regime, but only so long as the European Central Bank (ECB) is prepared to modify the structure of its assets by accumulating an ever-rising proportion of bills issued by any ‘weak’ euro country. For instance, if one of the ‘euro’ countries starts importing too much and makes no modification to fiscal policy, the ex ante effect will be to raise the proportion of bills issued by that country and held by the ECB — in successive stages and without limit. If this becomes unacceptable, at least within the confines of the model (and always given the assumption about three independent fiscal policies), the interest rate of the deficit country must give way and become endogenous. But this would bring about an exploding situation, as the interest rate of the weak country would need to increase for ever.