European Monetary Union
The final stage

Despite the enormous literature on the European Community's planned economic and monetary union (EMU), there has been little analysis of the ultimate step: the replacement of national currencies with a single currency. In Discussion Paper No. 591, Research Fellow Alberto Giovannini considers such a replacement of the several national currencies with a single currency, when holders of cash balances obtain new bank-notes by presenting the old ones and all outstanding nominal assets and liabilities are rewritten.
When a single country undertakes a reform, its government has an unconstrained choice of conversion rate without affecting real variables. When two countries introduce a common currency, however, their conversion rates are constrained because they determine the exchange rate between the two `old' currencies at the time of the reform. If this differs from their nominal exchange rate immediately before the reform, then with flexible prices the reform will affect the real economy through the wealth and substitution effects of changes to the real money stock.
Giovannini disputes the view that relative price distortions arising from the `less-than-full' credibility of the current gradualist plan in some participating countries may justify a `final realignment' when the single currency is introduced. Unless the public displays a form of money illusion by mistakenly applying the official conversion rates to translate outstanding nominal contracts, no exchange rate devaluation at that point could significantly affect relative prices. Mandating conversion rates acts as a form of incomes policy by imposing a new set of real payments on private agents' outstanding nominal contracts. If governments wish to correct misalignments that arise from the lack of credibility of the fixed exchange rate, they should choose the conversion rate for prices and wages that will induce precisely the exchange rate depreciation that wage and price setters originally expected. Eliminating exchange rate surprises will thereby eliminate distortions and minimize the welfare costs of expectations errors.
This suggests that transition to a single currency could be smoothed by announcing the conversion rates in advance say two years ahead as the intentions of the individual governments, endorsed by the Commission. This would allow the necessary adjustments to take place if credibility problems arise, for example from unforeseen exogenous shocks. If the conversion rates are credible, the economies will have time to adapt to them, and the final reform will entail only minimal disruptions; if they are not credible, governments should act to ensure that expectations are fulfilled.

The Currency Reform as the Last Stage of Economic and Monetary Union: Some Policy Questions
Alberto Giovannini

Discussion Paper No. 591, October 1991 (IM)