DP2068 EMU in Reality: The Effect of a Common Monetary Policy on Economies with Different Transmission Mechanisms
The theory of optimal currency areas states that a single currency zone should have symmetry of shocks and structures across regions. Research on monetary union in Europe has either assumed these conditions to hold close enough not to cause problems, or has focussed on asymmetries in shocks. But what if economic structures and/or market responses differ between countries or regions? This paper examines the consequences of a single monetary policy when there are asymmetries in a) the monetary transmissions; b) the wage/price transmissions; and c) private sector asset holdings. We find the first and last destabilise the business cycle, and put countries out of phase with one another in a way that cannot be corrected by deficit constrained fiscal policies. The effect is to delay convergence.