European Monetary Union
A German model?

European monetary union is expected to bring major economic benefits by reducing transactions costs and eliminating risk premiums on exchange rates. Its main cost is the loss of nominal exchange rate flexibility as a means of adjustment to changes to real exchange rates (RERs) among member countries. In Discussion Paper No. 660, Research Fellow Jürgen von Hagen and Manfred Neumann argue that earlier studies based on observed inter- regional exchange rate variances in Canada and the US are unsatisfactory comparators, since their economies are structurally very different from Europe and have probably been exposed to quite different shocks in the past. They instead compare variations in RERs during 1973-89 for six West German Länder, measured by differences in the movements of their price indices, and for their aggregate and eight other European countries, which also reflect nominal exchange rate changes. Calculating standard deviations for monthly, quarterly, semi- annual, and annual changes for 1973-8, 1979-82, 1983-6 and 1987- 9, they find that the standard deviations between Germany and Austria/Benelux were 2.5-6.0 times greater than the intra-German deviations during 1973-8, while those for France, Italy and the UK were 9-13 times larger. By the late 1980s, Austrian/Benelux standard deviations had declined to the levels found within Germany in the 1970s, while those for France, Denmark and Italy were comparable to those of Austria/Benelux in the mid-1980s. For the UK, which did not participate in the ERM in the 1980s, RER variability with Germany increased at high and low frequencies during the early 1980s, declined at monthly and annual frequencies, but increased at intermediate frequencies during the mid-1980s; it exhibited a general decline in the late 1980s, which may reflect Britain's period of `shadowing the Mark'.

Von Hagen and Neumann conclude that a common currency area could be viable for Austria, Benelux and Germany, but that it should not include Denmark, France, Italy or the UK. The greater variability of their RERs relative to Germany seems to result from asymmetric real shocks, rather than imperfect monetary coordination (except for the UK), so a premature monetary union including these countries would experience large regional imbalances requiring a regional stabilization mechanism. Von Hagen and Neumann therefore favour a `two-speed Europe', with Austria, Benelux and Germany forming the initial `core', which the remaining countries could join once they achieve comparable RER variability. If this is deemed politically unattractive, a large EMU should be postponed until further economic adjustment and convergence have occurred within the current arrangements of the EMS.

Real Exchange Rates Within and Between Currency Areas: How Far Away is EMU?
Jürgen von Hagen and Manfred J M Neumann

Discussion Paper No. 660, June 1992 (IM)