We are still some way from the establishment of a European Central Bank and Economic and Monetary Union. It is important to assess the relative merits of the EMS and of EMU and to investigate what would happen if the EMS broke down, leading to freely floating exchange rates. In Discussion Paper No. 358, Research Fellow Frederick van der Ploeg compares the performance of floating exchange rates, a managed hegemonic regime like the EMS, and irrevocably fixed rates with centralized monetary policy in the face of adverse demand and supply shocks. He uses a standard two-country Mundell-Fleming model, extended to allow for rational expectations and wage-price dynamics. It assumes perfect capital mobility, imperfect substitutability between goods produced in different EC countries, and internationally immobile labour within the EC. The robustness of the analytical results is investigated by means of numerical simulations.
In the face of an adverse demand shock common to both countries, monetary policy relaxes to ensure full employment. There is no conflict over the cost of living, and so no need for policy coordination under any regime. In the face of an uneven demand shock, such as a shift in preferences from one to the other country's output, EMU performs very badly compared with the other two regimes, because the exchange rate cannot depreciate and rigidities prevent adjustment through labour markets.
In the face of a common adverse supply shock, EMU performs much better than floating exchange rates, because competitive appreciations are avoided: a non-cooperative float leads to too tight monetary stances and excessive unemployment. Germany is worse off under the EMS than under EMU, because other currencies can appreciate against the Deutschmark, disinflating away some of the adverse consequences of a common supply shock, while the rest of Europe is better off under the EMS. This may be one of the few reasons why Germany may gain from a more symmetric arrangement, van der Ploeg notes. In the face of an uneven adverse supply shock, EMU leads to a much worse average European welfare loss than either a cooperative or a non-cooperative regime of either floating or managed exchange rates, because the currency of the affected country cannot appreciate in response to excess demand for goods.
The move towards monetary union in Europe is thus much more justified in the presence of common than of uneven shocks. Because labour markets do not clear and cultural and language barriers prevent a high degree of labour mobility, van der Ploeg argues, EMU must be accompanied by an appropriately designed European fiscal institution, to compensate for the loss of independent monetary and exchange rate policy

Monetary Interdependence under Alternative Exchange-Rate Regimes: A European Perspective
Frederick van der Ploeg

Discussion Paper No. 358, November 1989 (IM)