Monetary integration and the national adjustment process, macroeconomic policies of deflation in a small open economy : the case Denmark

Abstract

Monetary integration theory, of mainly a monetarist orientation, from the last decade, tends to show the adjustment process to uniform rates of domestic inflation as a mechanistic outcome of a harmonization of national supplies of credits. This belief that credit restraint is the panacea for balance of payments disequilibria is based on the dictum that the exchange rate is the relative price of two monies, hence the adjustment process is mainly a question of having national money supplies converging. Indeed the present study shows that the adjustment process for a small inflation prone open economy is far more complicated. The process is burdensome and tedious, and by interpreting external disequilibria as a fiscal phenomenon, this study suggests that a broader range of instruments be used. The previous over reliance on restrictive monetary policies combined with a high degree of short to medium term autonomy for fiscal policy have had serious structural repercussions by changing the pattern of production and consumption for the economy. The resulting squeeze on the tradeables sector as a direct result of restrictive monetary policies, shifts the adjustment burden from the nontradeables sector to the tradeables sector. The result, as demonstrated in the present study, is a chronic expansion of the public sector, which in turn makes future adjustment yet more difficult. The chances are now that the economy will experience a new variety of a "vicious circle", from overvaluation of the currency to a permanent expansion of the public sector.