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254 Unemployment and Monetary Policy in the European Union
to transfer it through higher prices. What actually happens thereafter depends
critically on the response of the monetary authority.
4.4.2 The Basic Dilemma: To Accommodate or Not
The fundamental choice confronting the Central Bank is to accommodate or not
to accommodate.
Non-accommodation means not changing the money supply and the exchange
rate (keeping both on the initial path). It is not a very appealing policy, because
it can be expected to have a series of costly consequences such as an insufficient
real money supply, a rise in unemployment and a fall in net exports (see 5.1
below). This last effect implies that non-accommodation may not be pursued
indefinitely, as it is likely to result in an unsustainable drain of reserves and of
accessible foreign credit, terminating in a balance of payment crisis. This in turn
would necessitate further measures restricting demand and employment or force
abandonment of fixed exchanges and of non-accommodation.
But accommodation can also be very risky. It means trying to maintain an
unchanged real money supply by letting the nominal supply rise in proportion to
prices. This policy, together with a floating exchange or an appropriate devaluation
of the nominal exchange rate, would make it possible for the producers, who
largely control prices, to transfer the whole wage rise into higher prices, with no
real effect on output or employment. While this would protect employment, it
would do so by totally undoing the gain in the real wage that labor had sought
and initially obtained. In the light of their new real target, they can be counted
upon to renew their push for nominal wage increase, which, if accommodated,
will lead to another round of price increases and so on, opening the way to the
traditional wage-price spiral.
In other words, to the extent that wage increases higher than the rise in productivity
lead to rising prices, a policy of accommodation of that rise may not
produce just a one time price increase, but risks to open the way to a steady inflationary
spiral. And this conclusion will be reinforced with escalator clauses aimed
at preventing higher prices from eroding the real wage.
Because of the high cost of non-accommodation, there might be a strong temptation
to start on an accommodation path maintaining the real money supply, considering
also that, in the beginning, the cost may be only a modest rise in inflation.
But the problem is that, failing a lucky break, the solution risks to prove unstable,
as the rise in prices could eventually turn into an inflationary spiral.
It would therefore seem unadvisable for a central bank to engage in a policy
of accommodation unless it has sound information that the accommodation would
not turn into an inflationary spiral that the central bank could not tolerate, especially
in today’s climate when central banks are assigned the major responsibil-