In Discussion Paper No. 1498, Matthew B Canzoneri, Javier Vallés and José Viñals seek the answers to the following questions: First, among potential EMU participants, can much of the variation in the relative national outputs be explained by money and financial market shocks as opposed to aggregate supply and demand shocks? Second, can most of the variation in nominal exchange rates be explained by the same shocks that account for the movements in relative national outputs?

The empirical results show that while most of the variation in relative national output can be explained by aggregate supply and demand shocks, these shocks nevertheless play a very limited role in explaining movements in nominal exchange rates. As a consequence, nominal exchange rates do not seem to respond much to the shocks which create macroeconomic imbalances, thus reducing their value as a tool for macroeconomic adjustment. The main policy conclusion follows immediately: Not only narrow, but also larger monetary unions may be viable in Europe because exchange rates do not appear to have played the shock absorber role that the literature suggests, nor do they seem likely to in the future. The authors claim that the costs of EMU have previously been exaggerated.


Do Exchange Rates Move to Address International Macroeconomic Imbalances?
Matthew B Canzoneri, Javier Vallés and José Viñals