EMU, Adjustment, and Exchange Rate VariabilityWP/98/50-EAWP/98/50 .EMU, Adjustment, and Exchange Rate Variability. Prepared by Luca Antonio Ricci and Peter Isard Previous studies have analyzed how European Monetary Union (EMU) is likely to affect exchange rate variability by focusing on the game-theoretic interactions of monetary authorities or fiscal authorities or both. This paper instead emphasizes the role of the sectoral dimension of international macroeconomic adjustment. It develops a three-country, three-good, factor-specific model of trade in which to investigate the short-run adjustment to demand and supply shocks in the presence of wage rigidities. This framework allows comparisons, for each type of shock, of the response of the exchange rate of the monetary union currency (versus an external currency) with the response of a weighted average of the bilateral exchange rates of each of the two candidates for the union (vis-à-vis the outside one). Three types of exchange rate weights are considered in the comparisons: country-size weights, trade weights, and equal weights. Whether EMU increases or reduces exchange rate variability is shown to depend on the relative importance of different types of shocks (demand or supply), on both the sizes and the specialization patterns of the countries forming the union, and on the weights that are assumed to be relevant for the comparator basket. The analysis is first carried out under the assumption that money supplies are exogenous. It is then extended to the case of optimizing monetary policies that attach quadratic losses to both inflation and employment variability. For comparisons based on country size or trade weights, the assumptions about monetary policy do not affect the qualitative nature of the results. Thus, in contrast to conjectures by Kenen (1995), Bergsten (1997), and others, the analysis suggests that optimization of policy objectives does not necessarily imply that EMU will lead to greater exchange rate variability. |