EMU, Adjustment, and Exchange Rate Variability


.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.