EMU will entail the loss of the exchange rate as an independent policy instrument to cope with asymmetric shocks to the member economies. If goods and factor prices were sufficiently flexible for immediate relative price adjustment, this loss would pose no problem for macroeconomic stability. Nominal rigidities, however, limit the role of this adjustment mechanism. Costs associated with the movement of labour and physical capital limit the effectiveness of factor mobility for adjustment in the face of asymmetric shocks that are transitory. As a result, it is feared that EMU will aggravate the national output and employment effects of transitory asymmetric shocks.

According to Research Fellow Jürgen von Hagen and George Hammond in Discussion Paper No. 1170, existing monetary unions commonly provide such stabilization through the national or federal fiscal system. This requires a minimal size of the central government budget to be effective, however. The authors study the alternative potential of an such an insurance system using historical data from the 12 economies of the EU prior to the last enlargement. The evaluation focuses on the performance of alternative arrangements rather than their practical implementation. Each alternative is judged in terms of the size and direction of the payments, and their budgetary and distributional implications. The simulations show that stabilizing asymmetric shocks around a common trend may amplify the univariate variance of GDP for some member countries. The price of simplifying the design of the transfer scheme can be very high, and it is suggested that the monetary union would operate more smoothly if monetary integration were to be undertaken after a high degree of economic integration has already been realized. Furthermore, the EU may well be better off without inventing an insurance mechanism against asymmetric shocks.

Region Insurance Against Asymmetric Shocks. An Empirical Study for the European Community
Jürgen von Hagen and George W Hammond

Discussion Paper No. 1170, May 1995 (IM)