Wage moderation policy in Germany

In this paper we briefly discuss the current condition of the German economy and the proposals from the government in March 2003 to reform labour markets. These reforms involve various measures to reduce the generosity of benefits and to increase the incentives to work. In order to analyse these reforms we simulate a temporary reduction in German real wage growth and discuss how German output, inflation, and interest rate are affected, under two distinct ECB monetary policy rules. We discuss the possible forward looking reactions of the ECB to these reforms and argue that it would be wise to respond in a fully accommodating way. The sensitivity of the ECB to changes in European key macroeconomic indicators is tested by analysing a scenario involving a reduction in French, Italian and German wages. It appears that single country wage moderation policies increase the country's competitiveness relative to other European countries, and hence helps raise the output effects in that country. We also consider that interest rates are set according to pre- 1999 rules, with monetary policy more responsive to German conditions. German output would respond more quickly to the labour market reforms, but the long run consequences are the same, so there are no sustained benefits from an independent monetary policy.