According to the literature on optimum currency areas, the costs of monetary union consist of the inability to use independent monetary policy in order to achieve optimal adjustment to shocks. Work on the costs of EMU has therefore mostly centred on the shocks affecting the member countries. In Discussion Paper No. 1069, Hélène Erkel-Rousse and Research Fellow Jacques Mélitz use a structural VAR approach based on the long-run identifying scheme pioneered by Blanchard and Quah to assess the costs of a European Monetary Union. The approach is then applied to six EU members: Germany, Spain, France, Italy, the Netherlands and the UK.

Five shocks are identified in the analysis, three of them pertaining directly to the real exchange rate and net exports: shocks to the price of imported raw materials, the relative velocity of money at home and abroad, and net foreign demand (the difference between foreign demand for home goods and home demand for foreign goods). The remaining two shocks concern home absorption and supply. Relative velocity shock is the one that causes exchange rate jumps and therefore relates to the impact of monetary policy, while the absorption shock pertains to fiscal policy. The decomposition of the five shocks shows the association between individual shocks to be much lower than has often been recorded. The analysis indicates that independent monetary policy might be of little value outside the monetary union, and independent fiscal policy could serve to mitigate costs of adjustment later on, inside a monetary union. Major doubts arise about there being any significant costs of monetary union except for Germany and possibly the UK.

New Empirical Evidence of the Costs of European Monetary Union
Hélène Erkel-Rousse and Jacques Mélitz

Discussion Paper No. 1169, May 1995 (IM)