How to restore sustainability of the euro?

We specify an open-economy version of a two-region New Keynesian model for EMU and demonstrate that the result on the unsustainability of the euro with ever-mounting inflation differentials by Wickens (2007) does not hold in general. Strong fiscal consolidation and far-reaching successful structural reforms are needed to reach sustainability in terms of competitiveness and reduced public debt over the medium run. However, the current deflationary adjustment involves a major polarisation within the euro area. Debt relief within the union and internal devaluation in the debtor country may essentially alleviate the adjustment burden and shift it from the problem countries to the strong countries. An internal revaluation in the strong countries can markedly help the situation in the weak countries in the short run if the interest rate remains unchanged. JEL Classification: E43, E52, E62.