Possible Effects of European Monetary Union on Switzerland: A Case Study of Policy Dilemmas Caused by Low Inflation and the Nominal Interest Rate Floor

WP/97/23-EAWP/97/23



Possible Effects of European Monetary Union on Switzerland: A Case Study of
Policy Dilemmas Caused by Low Inflation and the Nominal Interest Rate Floor
by Douglas Laxton and Eswar Prasad


As the planned date for the third stage of European Monetary Union (EMU) draws
near, the spillover effects are likely to be felt in countries not just in the
EU but also outside it. Switzerland is one such European country that could be
considerably affected by the developments surrounding EMU.


This paper provides a simulation analysis, using a stylized open economy
macroeconomic model of Switzerland, of the possible effects of EMU on the Swiss
economy. A number of different EMU scenarios are analyzed and the potential
effects on Switzerland are examined. A possible outcome, of concern to Swiss
policymakers, is that uncertainties related to EMU could lead to capital flight
from EU currencies to assets denominated in other hard currencies, including
the Swiss franc. This could result in pressures for an appreciation of the
Swiss franc real exchange rate, with consequent adverse effects on domestic
output and employment in Switzerland.


The paper investigates alternative policy responses to both temporary and
persistent asset preference shifts in favor of assets denominated in Swiss
francs. The simulation results suggest that monetary policy is likely to be a
more effective tool than fiscal policy for stabilizing output in the short run.
The conduct of monetary policy is, however, considerably complicated by the low
levels of inflation and nominal interest rates (close to the nominal interest
rate floor at zero percent) currently prevailing in Switzerland. The model
therefore incorporates some innovative elements that capture possible
nonlinearities in the economy.both in the Phillips curve relationship and in
the demand for money. Alternative monetary policy strategies.including a
temporary exchange rate ceiling.are analyzed. The simulations suggest that
timely and forceful monetary policy responses to asset preference shifts could
be crucial for reducing short-run output losses and mitigating the associated
costs in terms of future increases in inflation.