Recent turmoil in the EMS has revived interest in proposals for EC monetary integration to proceed initially with a small group forming an inner core. In Discussion Paper No. 792, Research Fellows Alberto Alesina and Vittorio Grilli consider the trade-off between average inflation and variance of output for five potential member countries of a monetary union. National central banks set monetary policy independently by stabilizing inflation and output around target values that take account of national preferences. In a monetary union, however, the European Central Bank sets a common inflation rate and targets `European' variables. A `feasible' monetary union is one in which no member country becomes worse off by joining. For three countries with different preferences facing identical shocks that adopt a trade-off parameter by majority vote, Alesina and Grilli show that `France' and `Italy' must adopt `German' monetary policy to meet the feasibility constraint.

Germany is indifferent about joining, so if any `new' type of shock hits Germany alone the `German' trade-off will no longer be feasible; for a large enough shock the feasible set may become empty, which in this framework may account for the strains imposed on the ERM by rises in government borrowing and interest rates following German unification. Also, if France and Germany unify their currencies first, both will be better off than with any equilibrium choice in a feasible five-country union, so they will never admit the other three as a group. Even if they admit Italy alone, there will still be a two-to-one majority against new members that attach lower weights to low inflation. The number of speeds with which EMU proceeds is therefore critical: the most `credible' low-inflation countries will strongly support a `multi-speed' union, from which they cannot lose. Either the other countries will change their behaviour and their subsequent admission will be costless, or the union will stop with the first group. Alesina and Grilli conclude that embarking on EMU at `two speeds' risks jeopardizing full European integration.

On the Feasibility of a One- or Multi-speed European Monetary Union
Alberto Alesina and Vittorio Grilli

Discussion Paper No. 792, June 1993 (IM)