Exchange Rate Policy in a Monetary Union 7

Richard Bart, and Chorng-Huey Wong
Published Date:
June 1994
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There have been many developments in the European Monetary System (EMS) recently, as well as debates over the eventual approval of the Maastricht Treaty agreed to in December 1991. But this paper will start from a somewhat more general perspective than just economic and monetary union (EMU) in Europe, first considering the reasons for a monetary union and the characteristics of a successful monetary union—that is, what makes the benefits of monetary union outweigh the costs of joining. Then the paper will move to some of the issues more specific to Europe, in particular the Maastricht Agreement and the transition to EMU.

I. Defining Monetary Union

What exactly is meant by “monetary union” or “common currency area”? The two should be distinguished, because, in principle, it is possible to have monetary union without replacing national currencies with a common currency. What is required in a monetary union is a common monetary policy, assuming the absence of various controls on capital flows or segmentation of financial markets. The very nature of a monetary union precludes separate monetary policies, and so, essentially, a monetary union has the characteristics of a common currency area, but no single circulating currency. Several currencies can coexist, provided their rates of exchange are fixed (and viewed as irrevocably fixed). This latter requirement can be a problem, as the turbulence in the EMS has demonstrated. Even though governments say that exchange rates or central parities are “irrevocably fixed,” as long as there are different currencies, there will also be doubts about whether this remains true.

Monetary unions have historically taken several forms. A union could be the area in which the currency of, for instance, a dominant country circulates, because this currency is viewed as more stable or as having more of the characteristics of money than the currencies of smaller countries in the region; or it could involve setting up international institutions, and, of course, in Europe, that is the framework of the Maastricht Treaty. In Africa, as well, there are supranational institutions in the CFA franc zone.

Assessing benefits and costs

Clearly, such arrangements offer certain benefits: they permit a common currency to circulate in a large area, or they reduce transaction costs when several currencies circulate at a fixed rate (as opposed to flexible rates with higher transaction costs). More generally, such schemes reduce uncertainty by creating a single currency and a more stable basis for anchoring prices. But monetary unions also have their costs, primarily the loss of the exchange rate as an instrument for cushioning shocks. And this question of the costs of losing exchange rate flexibility has given rise to a large literature that is, perhaps misleadingly, characterized as covering “optimal currency areas,” when in fact it attempts to assess the conditions under which the costs are reasonably small and hence outweighed by the benefits of a common currency.

Factor mobility

The initial insight of Robert Mundell was that factor mobility—and in particular labor mobility—reduces the costs of monetary union.1 If one region of a currency area experiences an unfavorable shock—for instance, to the demand for the goods that it produces or to supply conditions—the exchange rate may help cushion that shock, making its goods cheaper and more salable abroad, thereby maintaining employment. In a common currency area, where the exchange rate cannot serve this purpose, labor mobility may substitute for exchange rate flexibility. Although there may be costs to those who actually have to move from one region to another, the overall cost to the economy is less if there is some degree of labor mobility.

Labor mobility is one issue that has been much discussed in the European context, because it is expected to help limit the dispersion of unemployment rates in different regions. Compared with the European Community (EC), the United States—and, to some extent, Canada—has much less dispersion of unemployment rates (Chart 1). There is less labor mobility in Europe than in North America, especially the United States. Other evidence on migration—for instance, between countries in the EC—clearly suggests that migration in Europe is much lower than in either Canada or the United States. There are a number of reasons for this: language differences and the fact that social benefits are not transportable are among them.

Chart 1.Dispersion of Unemployment Rates1

Source: International Monetary Fund, World Economic Outlook (various issues); and IMF staff calculations.

1 Coefficients of variation, i.e., standard deviations of unemployment rates, scaled by the mean (components are weighted by population).

2Twelve current members, excluding Luxembourg, for which data were not available.


A second factor that may make the costs of monetary union less severe relative to the benefits is a high degree of interdependence among neighboring countries. This factor applies strongly to Europe, since the creation of the Single Market and the anticipation of even greater trade flows among EC countries have increased both the importance of transaction costs in exchanging currencies and the advantages of moving to a single currency. However, not all common currency areas have extensive interregional trade (Table 1). Clearly, the amount of trade among EC countries is quite high—higher, for instance, than trade between Canada and the United States, which is itself extensive in comparison with trade among other countries. The countries in the CFA franc zone, for instance—another example of a monetary union—have very little common trade. Including their trade with France, the ratio to total trade is quite substantial. Adding France’s trade to the denominator, however, makes the rate quite low. Interdependence need not be the primary criterion for deciding whether a currency union is appropriate.

Table 1Selected Country Groupings: Intra-Area Trade as a Share of Total Trade(Average, 1982–85)
Percent of

Percent of

Percent of

Total Trade
European Community
EC 12154.351.452.8
ERM 10252.750.651.6
North America
Canada and the United States37.434.535.7
Canada, the United States, and Mexico39.035.537.0
CFA franc Zone
CFA franc zone countries only36.610.78.6
CFA franc zone countries, including trade with France27.938.637.8
CFA franc zone plus France2.12.42.3
Source: International Monetary Fund, Direction of trade Statistics, various issues; and IMF staff calculations.

Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain and the United Kingdom. Data for Belgium and Luxembourg are consolidated.

EC 12 minus Greece and Portugal.

Benin, Burkina Faso, Côte d’Ivoire, Mali, Niger, Senegal, Togo, Cameroon, Central African Republic, Chad, Congo, Gabon, and Equatorial Guinea.

Source: International Monetary Fund, Direction of trade Statistics, various issues; and IMF staff calculations.

Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain and the United Kingdom. Data for Belgium and Luxembourg are consolidated.

EC 12 minus Greece and Portugal.

Benin, Burkina Faso, Côte d’Ivoire, Mali, Niger, Senegal, Togo, Cameroon, Central African Republic, Chad, Congo, Gabon, and Equatorial Guinea.

Sectoral diversification

A third criterion, which is important in minimizing the unfavorable effects of shocks to countries in a currency union, is a high degree of sectoral diversification of each of the country’s economies. The more similar the countries are in industrial structure, the less likely they are to be hit by shocks that affect their economies differently—and against which exchange rate flexibility is often the best protection. For instance, because of its dependence on relatively few primary commodities and agriculture, Australia may be hit by terms of trade shocks that make exchange rate flexibility important. In contrast, European economies are very diversified; though Table 2 gives only a very broad breakdown, it shows that the relative importance of primary commodities in Europe is small. Only Greece has a large output share for agriculture. Energy production is also not very important for European economies: the Netherlands and the United Kingdom have somewhat higher ratios than other EC countries, but no higher than Canada, for instance.

Table 2Industrial Countries: Shares of Production, 19861(In percent)
Agriculture2ConstructionEnergy and

United States2.35.55.822.264.2
United Kingdom2.16.77.827.655.9
Source: Organisation for Economic Cooperation and Development, National Accounts data base.

GDP at current prices. Shares are scaled to sum to 100.

Including hunting, fishing, and forestry.

Mining and quarrying (including petroleum and natural gas production), plus electricity generation and gas and water distribution.

Excluding government services.

Source: Organisation for Economic Cooperation and Development, National Accounts data base.

GDP at current prices. Shares are scaled to sum to 100.

Including hunting, fishing, and forestry.

Mining and quarrying (including petroleum and natural gas production), plus electricity generation and gas and water distribution.

Excluding government services.

Wage and price flexibility

Clearly the decision to participate in a common currency area constrains a country’s monetary policy by fixing the exchange rate, and the degree of wage and price flexibility is crucial to the impact of such a nominal exchange rate choice. In the limiting case of perfectly flexible wages and prices, then the nominal exchange rate chosen is itself arbitrary and does not have consequences for the real economy. For Europe, a more relevant polar case is real wage inflexibility; if there is real wage inflexibility, the choice of exchange rate also will not affect the real economy, but, in fact, adjustment will have to occur—with potentially large costs—through unemployment.

Econometric models

These criteria are useful for considering currency unions; however, because there are several of them, econometric models that include the various linkages are essential in making an overall assessment of the potential impact of a fixed exchange rate or monetary union on an economy. The EC Commission undertook such an exercise in the context of a 1990 study that considered what the transition to a common currency might imply for the variability of inflation and output (Chart 2).2 The experiments, conducted using the IMF’s Multimod model, suggested that the EMS, in its early period—from 1979 until about the mid-1980s—had produced somewhat more output variability, but less inflation variability. The increasing rigidity of the exchange rate mechanism (ERM) was, the study suggested, reducing both output and inflation variability, and this perceived improvement would continue as Europe moved closer to the goal of monetary union—a monetary union with a monetary policy determined symmetrically by monetary conditions throughout Europe. This future was perceived as offering better results than the EMS accompanied by fixed exchange rates—elsewhere it has been called an asymmetric EMU—with the Bundesbank basically setting monetary policy for Europe. In all, the study is a fairly reassuring view of the benefits of monetary union in Europe.

The IMF has also looked at the question of output and inflation variability in the context of shocks hitting Europe under different monetary regimes. The results are summarized in the box in Chart 3 that considers outcomes for all of Europe. One finding indicates that when countries target either their money supplies or a European money supply, a symmetric EMU with a European monetary target seems to give the lowest output and inflation variability. However, the other alternatives seem to be ranked differently from those of the EC Commission. The IMF has also done other experiments, assuming a nominal income target as opposed to a monetary target, and the outcomes were fairly sensitive to this assumption. On the basis of these results, the case for EMU may be somewhat less strong than the EC has argued.

Chart 2.Macroeconomic Stability of EMU

This graph plots the combinations of variability of output (GDP) and inflation for the EC average in index form, as resulting from the stochastic simulations. The position of each of the four regimes (‘free float,’ ‘EMS,’ ‘asymmetric EMU,’ and EMU) corresponds to an intersection between a regime-dependent output-inflation trade-off curve and a shifting preference curve.

Source: Stochastic simulations with the Multimod model of the IMF under the responsibility of the European Commission services. GDP is measured as a percentage deviation from its baseline value; inflation is measured in percentage point differences with respect to baseline inflation rates. The indices used in the graph are obtained by first averaging the squares of the deviations for 43 simulations over the period 1990–99 and then taking the square root. Dividing by the root mean-squared deviations for the free float regime and multiplication by 100 then gives the indices.

Chart 3.Floating Exchange Rates vs. the EMS and Symmetrie or Asymmetric EMU, with Money Exogenous

Source: IMF staff calculations.

MF = Floating rates.

R5 = EMS with realignment triggered by real exchange rate.

ME = Symmetric EMU, European money target.

MA = Asymmetric EMU, German money target.

Monetary and fiscal policies

The Delors Report and the subsequent Maastricht Treaty have considered the interaction between monetary and fiscal policies in some detail. The general argument is that it is not sufficient to create a common monetary policy, even when the central bank is formally separated from the fiscal authorities. There must be some constraints on fiscal policies, or these policies will interfere with monetary policy and may eventually force the central bank to monetize debt or bail out governments that would otherwise default on their debts. There is also the issue of the spillovers of different fiscal policies within a currency union; for instance, a country operating a very expansionary fiscal policy will clearly affect conditions in other countries in a different way than it would if the countries had separate currencies. In particular, an expansionary fiscal policy may, for a time at least, cause the exchange rate of all the countries in the union to appreciate against other countries. This argument suggests a need to coordinate fiscal policies within a monetary union.

Market forces

An important part of the debate concerns the question of whether markets will discipline fiscal authorities. Here again existing monetary unions with different types of fiscal authorities, such as the states of the United States or the Canadian provinces, become important reference points. The evidence suggests some degree of discipline, indicating that, in general, borrowing costs reflect objective criteria that make borrowing more difficult and expensive as debt increases. Of course, there have been times when the market has not anticipated problems soon enough. In the United States, for instance, the city of New York was unable to service its debt during the 1975 fiscal crisis; internationally, the Latin American debt problems of the 1980s were not reflected promptly in interest rates or in restrictions on lending.

Federal fiscal Policy

A final issue concerning fiscal policies in a currency union is the degree to which federal fiscal policy or transfers among regions are important. The argument in favor of transfers suggests that shocks affect regions or countries in the currency area differently; with no mechanism for adjusting to or cushioning those shocks that replaces the exchange rate instrument—such as a high degree of labor mobility—there must be a system of taxation and transfer payments to bring about compensating regional flows. In particular, the affected regions would pay less in taxes and receive higher transfer payments than the others in a federal fiscal system. A well-known study by Salai-Martin and Sachs3 argues strongly that the U.S. federal fiscal system plays a large role in cushioning shocks; in particular, the authors estimate that perhaps 40 cents of each dollar of the costs of an unfavorable shock in a region are recovered through lower taxes and higher transfers. The study points out that the absence in Europe of a federal fiscal system with this magnitude of flows between countries may create serious problems for monetary union.

It is important to distinguish between redistribution among regions—that is, poor regions receiving favorable fiscal treatment on a more or less permanent basis—and the stabilization role of fiscal policy. Is the issue shocks that produce temporary losses of output and hence can be cushioned, or is it the need for long-term development assistance to poorer areas? Chart 4 plots the variation across U.S. states or Canadian provinces of pretax income and income net of taxes and including transfers. A large degree of compensation through the federal fiscal system would produce a very flat slope, since redistribution would compensate for any large variations before the fiscal flows, and there would be rather little variation in the net incomes of the cross-section. The chart shows some flattening, but it is barely perceptible. Tamim Bayoumi and I found much more redistribution in Canada than in the United States, but no more than 20 cents or so out of the dollar.4

Chart 4.Federal Fiscal Flows and Personal Income

Source: Tamim Bayoumi and Paul R. Masson, “Fiscal Flows in the United States and Canada,” European Economic Review (forthcoming).

In the EC, at least under existing structural funds and a proposed cohesion fund, the amount of redistribution would also be fairly modest, perhaps on the order of a few percent. Still, there is a considerable difference between the North American countries and the EC. We found a somewhat greater stabilization role for the federal system in the United States than in Canada; the EC has no such system. As mentioned earlier, this lack may present a problem for the EC. However, the counterargument to this need to link monetary union with fiscal federalism would be that national governments currently perform stabilization in Europe and would continue to do so under EMU, reducing the need for stabilization at the federal level. The issue of redistribution, which is potentially more serious, is related to convergence.


Convergence is an issue because it has generated one of the major debates leading up to the Maastricht Treaty and remains a topical question in Europe. To what extent is convergence, both real and nominal, a precondition for monetary union or, conversely, a consequence of union? In a monetary union, members adopt a common monetary policy, and in the long run, inflation converges. The need for convergence of inflation before monetary union is questionable.

There is no need to guarantee that regions in a monetary union will have the same real per capita income or any other measure of real convergence. In Europe, for example, there is clearly much less convergence of real per capita income than in the United States, where the regional variation is really quite modest—less than 5 percent in terms of the standard deviation of real per capita income (Chart 5). The regions comprise several states and may include quite poor states—West Virginia, for instance—but the nine census regions are comparable to the European countries in average size. For the 12 EC countries, the variation is much greater—on the order of 30 percent—and excluding the 3 poorer members of the EC (Greece, Portugal, and Spain) still leaves a substantial variation. Apparently, real convergence has not occurred in Europe. However, the evidence from the United States could be used as an encouraging sign that monetary union may encourage real convergence; in fact, a much longer run of data on the United States suggests that there has been considerable convergence over the past century.

Chart 5.Dispersion of Real Per Capita Output1

Source: International Monetary Fund, International Financial Statistics (various issues); and IMF staff calculations.

1 Coefficients of variation, i.e. standard deviations of real per capita output, scaled by the mean (components are weighted by population).

II. The Maastricht Treaty

The Maastricht Treaty includes four convergence criteria as preconditions for proceeding to Stage III of monetary union and an eventual single currency. The fiscal aspects are given some emphasis. There is a ceiling of 3 percent on deficits as a ratio to GDP and 60 percent on gross government debt—with some qualifications that leave considerable room for discretion in deciding which countries actually qualify. Countries may exceed the 3 percent deficit temporarily and must prove only that they are well on the way to reaching the 60 percent debt ratio, not that they have achieved it. Even so, the fiscal criteria are potentially constraining, given the current situation of a number of countries. And the existence of such criteria clearly reflects the view that fiscal policy can interfere very seriously with the operation of monetary policy and should be used to prevent countries with unsustainable fiscal policies from entering EMU and interfering with its operation.

Other criteria state that the inflation rates of entering countries must not exceed that of the three countries with the lowest inflation rates by more than 1½ percentage points and that, using a similar measure, long-term rates may be only 2 percentage points higher. In addition, the countries must not have initiated any realignments in the two preceding years.

While these rules may be open to interpretation in some special cases, the treaty takes a quite strong line on the various preconditions needed to proceed to monetary union and establishes a timetable that is also potentially constraining. The treaty calls for setting up an EC central bank, creating a supranational institution that would, in essence, run monetary policy. Countries would not compete to set monetary policy, but clearly the treaty makes no provision for developing EC fiscal powers on the scale of fiscal federalism in, for instance, the United States or Canada.

According to 1992 data, only France, Denmark, and Luxembourg satisfied all the criteria. Several countries, in particular Italy, Greece, and Portugal, needed substantial fiscal and inflation adjustment in order to meet the criteria (and more recent data makes this true of a wider set of countries). For instance, in Italy, the general government balance in 1992 was a little over 10 percent of GDP, the debt ratio was 110 percent of GDP, and the inflation rate was about 5½ percent for the year. The Maastricht criteria suggest that inflation should have been no more than about 4 percent. Also, long-term interest rates were much higher in Italy than the treaty permits. Of course, since the timetable calls for a move to Stage III on January 1, 1997 at the earliest, the 1992 data are not immediately relevant, but they do show the need at least for substantial fiscal adjustment. Other countries—including Belgium, France, Germany, Spain, and the United Kingdom—have less severe fiscal problems but also demonstrate a clear need to lower deficits in order to qualify for EMU.

How has individual countries’ ability to reach these convergence criteria been affected by the recent realignments in the EMS? As long as the inflation consequent on devaluation can be kept from producing a spiral of wages and prices, and given the fairly depressed economies, it is reasonable to be somewhat optimistic about the effects of the realignments, which have probably helped to create a more sustainable path toward monetary union. They have not solved any fiscal problems, but perhaps they have underlined the need for quick action on fiscal matters in, for instance, Italy, and the market has signaled that the countries must take the criteria seriously and be seen to do so early on.

The costs of Maastricht

In general, these deficit reduction policies should have a contractionary effect on the European economies, at least temporarily. How severe will the costs be? The problem with answering this question is that there are also costs to nonadjusting: clearly unsustainable fiscal policies could eventually lead to a financial collapse that would produce high interest rates or even to a drastic reversal that would have very negative effects on output. In short, continuing with unsustainable policies entails high costs, but these are hard to quantify. The nature of the comparison is a false one, in that unless the costs of not adjusting are accurately estimated, there is no baseline against which to make the comparison.

However, the IMF has done a limited exercise in examining the output effects of reducing the fiscal deficits to levels that would permit meeting the Maastricht criteria by the end of 1996. Even without taking into account the favorable effects on confidence of putting a halt to a clearly unsustainable fiscal policy, the output declines are relatively modest—certainly important in the case of Italy, but at the EC-wide level, rather small, as are the international impacts. There seems to be no cause for the concern sometimes expressed that meeting the Maastricht criteria will produce a deflationary bias not only to European economies but to the world economy. Moreover, after a few years of slower growth in output, the effects on output should become positive.

Speculative attacks and other issues

The issue of speculative attacks is very much in the minds of people who are looking ahead both to the treaty’s ratification and to the transition to Stage III.5 In this context, the issue is how quickly transition to monetary union should be made. The treaty clearly balances several considerations. The advantage of swift action would presumably be to minimize the time available for such speculative attacks. But establishing institutions—particularly the European central bank—will take time. In this regard, the treaty has established a fairly long period for the move to monetary union; thus, this issue is likely to receive some attention in the next few years.

There are also long-term issues, assuming that EMU is established. How wide should the ultimate membership be? Potentially, there are many other candidates for not only EC but also EMU membership. Will an expanding membership lead to the European currency unit (ECU) eventually becoming a dominant world currency? The issue of labor mobility—how will that evolve over time in the EC? Will increased labor mobility be necessary if a monetary union is created, especially if an EC-wide fiscal system is not created? These are some of the questions that can be answered only over time—and after the EC has moved closer to EMU than it has thus far.

Robert A. Mundell, “A Theory of Optimum Currency Areas,” American Economic Review 51 (September 1961); 657–65.

European Commission, “One Market, One Money: An evaluation of the potential benefits and costs of forming an economic and monetary union,” European Economy 44 (October 1990): 3–347.

Xavier Sala-i-Martin and Jeffrey Sachs, “Federal Fiscal Policy and Optimum Currency Areas,” in Establishing a Central Bank: Issues in Europe and Lessons from the U.S., edited by Matthew Canzoneri, Vittorio Grilli, and Paul R. Masson (Cambridge: Cambridge University Press, 1992), pp. 195–220.

Tamim Bayoumi and Paul R. Masson, “Fiscal Flows in the United States and Canada: Lessons for Monetary Union in Europe,” European Economic Review (forthcoming).

Ratification has been achieved; the treaty went into force on November 1, 1993.

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