Monetary arrangements in Europe vacillated wildly over the last decade, and they may be expected to continue to do so over the next. Much of the literature on this chaotic process of regime switching has (quite rightly) focused on issues of credibility. In Discussion Paper No. 1100, Research Fellow Matthew Canzoneri and Harris Dellas focus instead on the longer-run implications of Europe's choice of monetary regime, after the noise and confusion has abated. They calibrate a simple general equilibrium model to assess the impact on Germany, France, Italy and the UK of the process of monetary integration – starting with a flexible rate regime, passing through a hard EMS, and ending in EMU, with periods of flexible rates along the way.

Their more specific conclusions for Europe are as follows: a) Germany would seem to have relatively little to fear from EMU; b) the stock markets in Italy, France and the UK would benefit significantly from any monetary arrangement that lowers the anticipated rate of inflation; c) Italy would benefit unambiguously from either a hard EMS or EMU, because of the high volatility of its output and its relatively low covariance with US output: prices and exchange rates would both be stabilized; d) France's `franc fort' policy involves a trade-off between price stability and exchange rate stability; e) the UK seems to have the same trade-off, but going in the opposite direction; f) moving to EMU would stabilize prices and exchange rates in all countries, unless the new central bank tried to target the money supply instead of nominal income; and g) `news' affecting expectations of inflation may be contributing directly to the current instability in national stock markets.

Monetary Integration in Europe: Implications for Real Interest Rates, National Stock Markets and the Volatility of Prices and Exchange Rates
Matthew B Canzoneri and Harris Dellas

Discussion Paper No. 1100, January 1995 (IM)