Economic and monetary union as proposed by the Delors Committe Report entails clear benefits from the elimination of transactions costs and exchange rate uncertainty, and possible reductions to information costs. Increased financial integration may also enhance the benefits of the 1992 single-market programme, and monetary union may provide a lasting basis for central bank independence and price stability, while the ecu's development into a major international currency would enable European central banks to economize on their holdings of reserves.

In Discussion Paper No. 517, Research Fellows Andrew Hughes Hallett and David Vines investigate the costs of such a union principally those involved in absorbing a shock or adapting to some disequilibrium tendency. They illustrate these costs with a model of two identical economies, whose policy- makers have identical preferences. They subject these economies to symmetric and country-specific shocks. They find that a monetary union presents four main difficulties compared to the bench-mark of floating rates.

First, there can be no `relative' monetary accommodation to deal with asymmetric shocks, which therefore impose greater adjustment costs, although inflation may be disciplined more quickly. Second, although EMU implies greater relative discipline against inflation from the centre, it provides no control over the absolute price level, so the average levels of price increase to which member countries converge may be no lower than those without EMU. Indeed, they may be higher: if inflationary pressures spread throughout the union, each inflationary country will suffer smaller pay rises, but more countries will be affected so the overall price index will rise at least as much as without EMU. This may benefit small, inflation-prone economies on the periphery, but it will damage the larger, low-inflation economies in the core.

Third, EMU tends to generate an unfavourable distribution of benefits in that many of the corresponding costs appear at the national level but not in the European aggregates, so European policy-makers may fail to see the problems motivating national deviations from proposed Community-wide policies. Fourth, fiscal flexibility is required to smooth the increased fluctuations in output and investment that will appear once intra-EC exchange rates have been stabilized. Hughes Hallett and Vines conclude by proposing a softer form of monetary union that forbids relative accommodation in the long run, but permits it in the short run; but they leave the design of an absolute anchor for a monetary union as a topic for future research.

Adjustment Difficulties Within a European Monetary Union: Can They Be Reduced?
Andrew Hughes Hallett and David Vines

Discussion Paper No. 517, March 1991 (IM)