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Working Paper Summaries (WP/94/1 - WP/94/76)
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Working Paper Summaries 94/65: Relative Prices and Economic Adjustment in the U.S. and the EU: A Real Story About European Monetary Union

Author(s):
International Monetary Fund
Published Date:
August 1994
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The prospect of European Economic and Monetary Union (EMU) has created interest in a number of issues associated with the operation of monetary unions. The most basic effect of a common currency will be to eliminate the ability to vary bilateral exchange rates within the union. It is a widely held view that this loss of the exchange rate instrument will reduce the ability of the participating economies to absorb disturbances.

This paper looks at the empirical relationship between fluctuations in relative prices and real output across the European Union (EU) and across regions of the United States using structural vector autoregressions. A comparison of the behavior of EU countries, which have close economic ties but separate currencies, with regions within the United States--a currency union of roughly comparable economic magnitude--can be expected to shed light on how the existence of a currency union influences the response of the economy to underlying disturbances.

The results indicate that the United States has significantly more integrated goods and factor markets than the EU. As a result, relative price variability is more important for adjustment within the EU than it is within the United States, despite the fact that the size of the underlying disturbances is relatively similar. The paper finds that adjustment occurs quickly within the EU, largely within a year or two, presumably reflecting the flexibility in relative prices implied by adjustable nominal rates of exchange. In the United States adjustment is much slower, plausibly reflecting the greater importance of factor mobility in adjustment.

Exploring the implications for EMU, the paper suggests that by adopting a single currency the EU is likely to reduce the short-run flexibility of relative prices, making it more difficult and costly to adjust to underlying disturbances. In the longer term, increasing integration of EU goods and factor markets should reduce the need for large movements in relative prices. Institutional changes, such as the recent completion of the single market in the EU, are important in promoting this integration. In addition, the paper notes that EMU itself will probably promote greater flexibility than has been seen in the past.

Having said this, it does not appear likely that the EU will achieve anything like the levels of integration of U.S. regions in the immediate future. In the short run, disruptive relative price adjustments can probably be best avoided by reducing the size of underlying disturbances in demand for regional products. Coordination of domestic aggregate demand policies across EU countries, such as the fiscal restraints incorporated in the Maastricht treaty, is one method of moderating the teething problems likely to be associated with EMU.

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