EC Enlargement
EFTA in EMU

Opinions on the degree of policy convergence required as a prerequisite for EMU vary: Germany and its immediate neighbours favour close harmonization of economic policies first, while some other Community members argue for a rapid move to EMU, which would itself bring about convergence. A two-speed EMU might allow countries whose policies are already closely harmonized to form a monetary union immediately with the others initially remaining outside. EC enlargement further complicates the issue: if the two-speed option for EMU is chosen, the former EFTA countries must choose at which stage to join.

In Discussion Paper No. 646, Tamim Bayoumi and Research Fellow Barry Eichengreen analyse the costs to current EC and EFTA member countries of adopting the identical monetary and similar fiscal policies that EMU entails. If disturbances are distributed symmetrically across countries, symmetrical policy responses will suffice; otherwise, asymmetric policy responses are needed and the constraints of monetary union may bind. They use data on output and prices, distinguishing between supply and demand disturbances, to isolate disturbances using the identifying restriction that aggregate demand disturbances have only a temporary impact on output, while aggregate supply disturbances have a permanent effect. They find that both demand and supply shocks to the EC core are significantly smaller and significantly more correlated across countries than those to the EC periphery.

Their results for the EFTA countries show that their speed of response to both aggregate supply and demand shocks resembles that of the EC core, but their intra-group correlation of both supply and demand shocks resembles that of its periphery. Austria, Sweden and Switzerland display aggregate supply and demand disturbances that are both relatively small and relatively highly correlated with those of Germany. Finland and Norway display larger disturbances, which are relatively poorly correlated with Germany's.

Bayoumi and Eichengreen conclude that including the current EFTA countries in EMU does not pose major challenge to current EC member countries since they exhibit behaviour midway between that of the EC core and periphery. If the EC proceeds with two-speed EMU, however, the more logical division of EFTA into two sub- groups implies that there will be more vehicles in both the fast and slow lanes.

Is There a Conflict Between EC Enlargement and European Monetary Unification?
Tamim Bayoumi and Barry Eichengreen

Discussion Paper No. 646, May 1992 (IM)