EMU and the International Monetary System
Chapter

14 Policy Implications of the Size of EMU for Europe and the United States

Editor(s):
Thomas Krueger, Paul Masson, and Bart Turtelboom
Published Date:
September 1997
Share
  • ShareShare
Show Summary Details
Author(s)
Fabio Ghironi and Francesco Giavazzi 

As the date approaches when a decision will have to be made on which European states will join the monetary union from the start, two separate camps are emerging in the countries that are likely candidates to be admitted to the currency union. On the one side lie the central bankers, the Bundesbank in particular, mainly concerned about the credibility and the reputation of the new ECB, and about the extent to which the countries that will adopt the euro will come close to forming an optimum currency area. On the other side lie industry and the trade unions, mainly worried about competitiveness, that is, about the effects that splitting Europe in two separate groups of countries, the “ins” and the “outs,” may have on relative prices inside the EU. The sophisticated argument is that the single market could not survive if exchange rate volatility between the ins and the outs were high. The unsophisticated argument is that both—industry and the unions—are frightened by the prospect of the outs using the exchange rate strategically.

The argument of the central bankers runs as follows. The ECB will not inherit overnight the reputation of the Bundesbank. For some time it will be carefully watched and tested by the markets—until it builds its own credibility and reputation. How long will it take for the ECB to achieve this? It depends, say the central bankers, on the type of countries that will join the currency union from the start. If the first group of ins consists of those countries that already belong to the “greater deutsche mark area,” building a reputation will not take long—as the ECB will look very similar to the Bundesbank from the start. However, as the number of the first group of ins increases, and the Board of the ECB starts speaking more and more languages (and languages that are increasingly distant from German), building a reputation will take longer and longer. Not only because the European Council will appoint to the Board of the ECB individuals from states whose anti-inflationary reputation is doubtful, but also, and perhaps more important, because the monetary union will include regions that less and less resemble an optimum currency area—thus increasing the pressures likely to be exerted on the central bank. Hence, conclude the central bankers, let us start with a small union; this will make it easier for the ECB to build a reputation and once this is achieved, more countries can be allowed in without prejudice to the new monetary institution, which by then will have a strong anti-inflationary reputation of its own.

While the reputation argument is certainly relevant (see De Grauwe, 1996, for an analysis), there are other dimensions to the choice of the optimal size of the currency union. An important one is the interactions that will take place among the various actors in the EMU game: between the ECB and the central banks of the outs; between the ECB and the fiscal authorities of the currency union, that is, the ECOFIN Council; between the central banks of the outs and their own fiscal authorities; and between these institutions and the rest of the world. (In this paper we think of the rest of the world as simply the United States, but further work should allow for the growing impact on Europe of other areas of the world, the Far East in particular.) For example, following a negative supply shock, if the outs were able to engineer a real appreciation, thus successfully shifting some of their inflation upon the ins, the ECB would have a greater incentive to contract its monetary policy and to export inflation to the United States, thus appreciating the euro against the dollar—the more so the larger the size of the outs relative to the EMU. If the Federal Reserve reacts by tightening as well, overall these monetary interactions would have negative consequences for employment both in Europe and in the United States, possibly against the governments' preferences.1

In Europe different policymakers are concerned about different aspects of these strategic interactions. Those based in the individual states are above all concerned with the consequences of a division of the EU between ins and outs: thus, the strategic interactions they are interested in are those that may occur between the authorities of one group of countries and those of the other. The European Commission, instead, works under the assumption that the transition will be short, and that the EMU will soon include all EU states. What worries the officials in Brussels are the effects on the international monetary system of the introduction of a new currency. This paper makes the point that these two aspects cannot be separated. The interactions between ins and outs cannot be studied in isolation, since they will be affected by the presence of the rest of the world—as hinted at in the example of the previous paragraph. The interactions between EMU and the rest of the world depend, in turn, on the size of the EMU and on the exchange rate regime between insiders and outsiders, and cannot be studied independently of the ins vs. outs question.

After a long period during which few in the United States believed that EMU would really happen, U.S. policymakers are now becoming increasingly concerned about developments in Europe. Changes in the size of EMU are likely to affect the way the authorities of the currency union will relate to the U.S. authorities. Also, if the outsiders are a very small entity, it seems intuitive that U.S. policymakers will be indifferent as to the nature of the intra-E.U exchange rate regime. Things may be different if the outs are a significant fraction of the EU.

This paper discusses the effects of different sizes of EMU and of different exchange rate regimes between the ins and the outs in a framework that explicitly accounts for the interactions between Europe and the United States. We study the incentives that various European policymakers face in determining the optimal size of the currency union and the choice of the intra-EU exchange rate regime, explicitly accounting for the effects of the interactions inside Europe and between Europe and the rest of the world. We overlook the ECB credibility problem—which is well understood—and ask if there are other reasons why the central bankers of the likely ins may want to keep the currency union relatively small. At the same time we ask if the optimal dimension of the union, as seen from the viewpoint of the fiscal authorities, is different, thus giving rise to a potential conflict between ECOFIN and the central bankers at the time of deciding who should join the union. Throughout the paper we discuss how the choices faced by European policymakers are affected by the presence of the United States (the rest of the world) and, in turn, how the United States will be affected by the birth of the euro and by the size of EMU.

The tool we use to address these questions is a three-country model designed to describe the interactions among monetary and fiscal authorities within each country and internationally. The model is in the tradition of Mundell and Fleming, as applied to the analysis of international policy interactions by Canzoneri and Henderson (1991). Among its attractive features is the fact that it allows us to study the effects of different dimensions of the European currency union—in a continuum that encompasses a union that extends to the entire EU (except perhaps for a few states of negligible magnitude) as well as one that does not extend beyond Germany and Austria.2 The model is described in detail in Ghironi and Giavazzi (1997a and 1997c), where we also discuss how the output-inflation trade-off facing the monetary authority of a region changes when its relative size and the monetary regime that links it to the rest of the world change. In the next section of this paper we provide an intuitive description of the most important features of this model.

As is common with three-country models—and we have argued above that three is the minimum number of countries that we can consider—some of the reduced-form coefficients of the model cannot be signed unambiguously. We must thus analyze the effects of the interactions among policymakers computing numerical solutions of the policy game among the various authorities using reasonable values of the parameters. Interestingly, our three-country model vindicates some of the facts described at the beginning of this introduction. For example, in a situation where fiscal authorities are prevented from using the tax instruments (and thus in a situation that closely resembles what could be the consequences of a strict “fiscal stability pact”), strategic interactions are limited to those occurring among central banks, and the intra-EU exchange rate regime is asymmetric (as in ERM II), the ECB would prefer the currency union to be rather small if the outs were nonnegligible. ECOFIN, instead, prefers a situation in which relatively more states join the currency union (see section on monetary policy interactions). In the same section, we compare these results with those obtained assuming monetary cooperation between the ins and the outs. The subsequent section is devoted to the analysis of what happens when fiscal activism is allowed. We then start exploring the importance of the United States by studying what would happen were the United States and Europe completely closed with respect to one another, that is, if there were no transatlantic policy spillovers. We find that the conflict of interests between the ECB and ECOFIN would disappear in this situation. Next, we reintroduce transatlantic policy spillovers and compare the results obtained under an asymmetric intra-EU regime with those obtained assuming a symmetric flexible exchange rate regime between the ins and the outs. The comparison, which is based on the results about the trade-offs summarized in the next section, sheds more light on the policymakets’ incentives and on the role of the United States in our analysis.

Analytical Framework

As is common in the literature on international spillovers of fiscal and monetary policies, the model we use for our analysis is essentially a three-country version of the Mundell-Fleming model, in which the authorities of each region minimize quadratic loss functions whose parameters differ across different authorities. This particular model was first studied in Ghironi (1993), and used to address different questions in Eichengreen and Ghironi (1997a and 1997b). The model is described in detail in Appendix I.3

Inside each region the central bank controls a nominal variable (the money supply or the level of the exchange rate), while the fiscal authority controls taxes or public spending. The interactions among different regions occur via trade flows in the goods market and via capital flows in the assets markets; we assume that assets are perfect substitutes, so that interest rates and nominal exchange rates in the three regions are linked through arbitrage conditions. We use the model to study the response to a common supply shock that hits the three regions simultaneously.4 The model has two periods: nominal wages are predetermined and set based on the expectation of future variables; the ex ante return on financial assets also depends on expected exchange rate changes. However, because the only stochastic factors are exogenous shocks, whose expectation one period ahead is equal to zero, the rational expectations solution of the model (in the absence of time-consistency problems, which we overlook) is straightforward, since all expectations are equal to zero; thus the model reduces to a static structure. (See also Giavazzi and Giovannini, 1989, for a similar solution.)

A distinct feature of the model is the assumption about fiscal policy. We rule out debt accumulation by imposing that tax revenue equals spending in each period. Government spending falls on home and foreign goods, according to the same pattern as for private consumption (to be described later). We follow Alesina and Tabellini (1987) in assuming that government revenue accrues exclusively from a tax on firms’ total revenues, which provides a simple way to capture the distortionary effects of taxation. Firms’ demand for labor is a decreasing function of the tax rate: for a given level of demand, a tax cut raises employment. This effect, however, is accompanied by the contemporaneous fall in demand produced by the cut in government spending that must accompany the tax cut. Hence, the net effect on equilibrium employment remains ambiguous, although for plausible parameter values the supply effect dominates—that is, a tax cut unambiguously raises employment.5 The fiscal authority responds to a negative supply shock (which raises prices and lowers output) by cutting taxes, thus helping to raise employment and to stabilize the price level because the tax cut creates excess supply in the goods market.

The trade pattern across the three regions (shown in Figure 1) is the novel feature of our model, which allows us to compare different sizes of the currency union. We start from the pattern of transatlantic trade: U.S. consumers spend a fraction (1 − b) of total consumption on home goods, and a fraction b on goods imported from Europe; this in turn is allocated in a fraction a, which falls on goods produced by the ins, and a fraction (1 − a), which falls on goods produced by the outs. European consumers in both regions spend a fraction b on goods imported from the United States, and a fraction (1 − b) on European goods; the latter fraction is distributed in a fraction a that falls on goods produced by the ins, and a fraction (1− a) that falls on goods produced by the outs.6 The parameter a characterizes the size of the currency union. As a increases, the share of U.S. imports from Europe that comes from the ins increases, while the import share from the outs falls, thus describing a situation in which the size of the ins relative to the outs increases. As a approaches 1, the EU and the ins tend to overlap: the currency union includes all EU states except for a small “residual” economy whose actions do not affect the ins and the United States. When a falls, the number of countries in the currency union becomes smaller and smaller.

Figure 1.The Pattern of Trade

As mentioned above, there are two authorities in each region: a fiscal authority and a central bank.7 Each policymaker minimizes a loss function, which includes, as arguments, the fluctuations of employment and the consumer price index (CPI) around their equilibrium values. In addition, the fiscal authorities also care about the volatility of taxation. There are various reasons for the inclusion of the latter in the governments’ loss functions. Governments are likely to care about the distortions they impose on the economy when using their instrument. In addition, penalizing fiscal authorities for an active use of their instrument is a simple way of capturing the relative rigidity that characterizes fiscal policymaking relative to the management of monetary policy. In the world economy we are considering, fiscal flexibility for stabilization purposes is likely to be limited for reasons that we elaborate on below. Our specification of the governments’ loss function allows us to capture in a simple way these constraints on the active use of fiscal policy to react to the consequences of disturbances.8

We shall first consider the case when no authority cooperates—neither internationally nor within each region. The monetary policy regime between the ins and the United States is symmetric, and, in the absence of international monetary cooperation, it is subject to the well-known inefficiency associated with flexible exchange rates. Each central bank controls its own money stock and believes that by changing it it can affect the bilateral exchange rate. Since exchange rates feed back into the domestic CPI, each central bank believes that monetary policy can affect prices at a relatively smaller cost in terms of output. In the noncooperative equilibrium, monetary policy turns out to be overly contractionary.

Within Europe, instead, we study two different monetary regimes. The first is asymmetric: the central bank of the ins (the ECB) controls its own money stock, but—contrary to the situation relative to the dollar—it is unable to affect the intra-European exchange rate because its partner (the outs) accommodates any change in the money stock of the ins. Therefore, the ECB minimizes its loss function subject to the Europe-wide trade-off between output and the price level. The central bank of the outs, instead, controls the bilateral exchange rate. The alternative regime is symmetric, exactly as we have assumed for the ECB and the Federal Reserve.

Which regime will characterize Europe after EMU is born is still undecided. Policymakers (the Commission and the ECOFIN Council) are oriented toward a new ERM, linking the single currency with the currencies of the outs: as argued in Giavazzi and Giovannini (1989), we believe that our asymmetric regime is a good characterization of an ERM-type arrangement whereby realignments are noncooperative. The alternative view—held by the U.K. authorities and by a number of academic economists; see in particular Persson and Tabellini (1996)—is that a new ERM (ERM II) would not survive speculative attacks, especially since the ECB would be unwilling to provide unlimited intervention. Instead the outs should concentrate on a domestic monetary rule (inflation targeting is the common proposal) and let the bilateral exchange rate vis-à-vis the euro fluctuate.9

Within this framework we ask whether different authorities (in particular ECOFIN and the ECB), concerned about the consequences of supply-side disturbances, would agree on the desirable size of the currency union and we analyze the policy implications of changes in the size of EMU for Europe and the United States.

Ghironi and Giavazzi (1997a and 1997b) use the model to derive a set of theoretical results on how the employment-inflation trade-off facing the monetary authority in an open economy is affected by the relative size of the economy and by the exchange rate regime. These results are important to understand the intuition behind the numerical solutions that we shall describe later, and they lend some robustness to the conclusions. The intuition runs as follows.10

The main point is that the trade-off a country faces depends on the size of the economy for which the monetary authority sets its instrument. Under a noncooperative flexible exchange rate regime, each central bank sets the money supply for its own economy, taking the money supply of the other country as given; thus, in such a regime, the relevant size for each central bank is that of its own country. Things are different, however, in an asymmetric regime, where one central bank (that of the core country) sets the money supply for the entire region, while the other central bank controls the bilateral exchange rate. In such a regime the relevant size for the central bank of the core country is the entire region, while the size that is relevant for the peripheral central bank remains that of its own country.

It can be shown that, in general, the trade-off a country faces becomes steeper—that is, it improves—the smaller the size of the “relevant” economy. A steeper trade-off allows the central bank to trade a larger inflation gain for a smaller employment loss. This is intuitively more favorable for sufficiently inflation-averse central bankers. Thus, when we argue that a steeper trade-off is better, we are implicitly assuming that central banks care more about inflation than about employment in their loss functions.11 The intuition is straightforward. Consider for instance the peripheral country in an asymmetric regime. The smaller the economy, the larger the share of imports in the domestic CPI. Thus, the impact of a given change in the exchange rate on the CPI increases as the size of the economy gets smaller—and thus it becomes more open. Therefore, a small open economy in principle needs to engineer a relatively milder recession to stabilize prices, compared with a large country where the exchange rate has only a small impact on the domestic CPI.

This result has two corollaries. Consider, first, the following comparison: the central bank of a peripheral country in an asymmetric regime, and the same central bank in a symmetric flexible exchange rate regime. The size of the relevant economy is the same in the two situations—and thus the tradeoff the central bank faces is also identical in the two regimes. This is not true, however, for the central bank of the core country in an asymmetric regime, compared with the situation under flexible exchange rates. The trade-off this central bank faces is always less favorable in the asymmetric regime, when the relevant economy encompasses the entire region, and the two trade-offs coincide when the size of the peripheral country becomes negligible—the Federal Reserve is indifferent between a regime of pegged-but-adjustable or flexible exchange rates vis-à-vis Grenada, but it clearly cares about the exchange rate regime vis-à-vis Germany or Japan.

These results are summarized in Figures 2, 3, and 4. Figure 2 shows the employment-inflation trade-off facing the peripheral country (the outs in our discussion of the European monetary union) in an asymmetric regime. (These figures are drawn assuming that the countries are hit by a supply shock that causes inflation and unemployment.) The steeper line—the one along which the trade-off is more favorable—corresponds to the case in which the size of the currency union is relatively large and, as a consequence, the outs are relatively small. Figure 3 illustrates the trade-offs when the exchange rate regime inside Europe is symmetric (flexible exchange rates) and thus coincides with the exchange rate regime between Europe and the United States. The size of the United States coincides with that of Europe: thus, the trade-off the United States faces is always worse than the trade-off facing the European countries and it coincides with the trade-off facing the ins when a = 1, that is, when the size of the outs is negligible. Inside Europe the smaller country faces the best trade-off, and the trade-offs coincide for a = 0.5. If, instead, the exchange rate regime inside Europe is asymmetric (see Figure 4), the central bank of the core country, the ins, always faces the same trade-off as the Federal Reserve, irrespective of the actual size of the ins’ economy, whereas the outs face the same trade-off they would face under the symmetric regime, which is always better than that faced by the ins.

Figure 2.The Outsiders Employment—Inflation Trade-Off

Figure 3Employment—Inflation Trade-Offs Under a Symmetric Regime in Europe

Figure 4.Employment–Inflation Trade-Offs Under an Asymmetric Regime in Europe

Monetary Policy Interactions Between the Ins. the Outs, and the United States

The general results stop with those discussed in the previous section—and this is not surprising. Remember that what we are looking for are situations in which some policymakers prefer a relatively larger currency union, while others prefer a relatively smaller one, but all policymakers minimize employment and price-level fluctuations, albeit with different weights. If it turned out that a given size of the currency union was best independent of parameter values, then policymakers would never disagree. Therefore, what we are going to show are situations in which, for instance, the policymakers that attach a larger weight to price level relative to employment fluctuations prefer, say, a relatively smaller union, while the opposite holds for policymakers with different relative weights.

Our first exercise considers only monetary policy interactions; we thus assume that the tax rate is held exogenously constant—for instance, because of an institutional constraint on the active use of fiscal policy. The three fiscal authorities passively watch the interactions among central banks, and their loss functions include only the employment and CPI terms. The three central banks do not cooperate, and the intra-EU exchange rate system is asymmetric.

We believe that this is a good characterization of the way EMU might work, at least for some time. The Stability and Growth Pact will tie the hands of the fiscal authorities of the ins, while the efforts to meet the Maastricht deficit criteria will in turn prevent the outs from actively using fiscal policy to respond to shocks. The constraints imposed by the Stability and Growth Pact are likely to be binding for a significant period—and the flexibility of fiscal policy for stabilization purposes correspondingly limited—also because of the problems European governments are experiencing in the presence of slow (or even negative) population growth and, in particular, costly social security systems.12 The assumption that monetary authorities do not cooperate is also a serious possibility. The ECB was designed to be independent; even if a new EMS-type arrangement is introduced, linking the currencies of the ins and the outs, it is likely that—at least in its first years—the ECB will not be inclined to compromise its objectives in order to cooperate with other central banks, in particular with those of the outs.13 As a result, the latter central banks could use the exchange rate strategically in the attempt to shift upon the ins some of the cost of adjusting to exogenous shocks—precisely as in the managed exchange rate regime described in the last section.

Within this institutional framework we investigate how purely strategic incentives will drive European policymakers at the time of deciding how many states should be admitted into the currency union. Although formally this decision is the responsibility of the European Council on a recommendation by ECOFIN, central bankers (the EMI at that stage, since the ECB will not yet be born) will be very influential. (The European Council will decide based on a recommendation by ECOFIN, which in turn will receive two reports, one from the EMI, and one from the European Commission.) We would like to know if the two bodies, ECOFIN and the EMI, will have different views, and what determines such differences.14 More precisely, we ask the following question: for a given policy regime—no cooperation among central banks, monetary policy asymmetry inside Europe, and frozen fiscal policy—following an exogenous supply shock, how large a currency union would each authority prefer, that is, how does the loss function of each authority change as the parameter a changes?

Solving the central banks’ minimization problem leads to the first-order conditions displayed in Appendix II. These define each central bank’s Nash reaction function to the other monetary authorities’ policy actions. The solution of the system, using our assumptions about the parameter values, together with the implied values of endogenous variables and loss functions, are summarized in Table l.15

Table 1.Effects of a Inoncooperative ERM II with Fixed Taxes
Outs’Size Negligible (a = 1)Outs’Size Small (a = 0.75)Outs’Size Equal to Ins’ (a = 0.5)
Ins’ money (ml−1.8423−1.8843−1.9060
U.S. money (mUS)−1.8423−1.8506−1.8550
Nominal outs/euro (e3)−0.2130−0.1815−0.1376
Real outs/euro (z3)−0.1168−0.0995−0.0754
Real dollar/euro (z1)0.0000−0.0127−0.0193
Real dollar/outs (z2)0.11680.08680.0561
Ins’CPI (q10.48050.51270.4977
Outs’ CPI (qo)0.26740.33120.3601
U.S.CPI(qUS)0.48050.48430.4813
Insȁ employment (nl}−1.5281−1.5680−1.5829
Outs’ employment (no)−1.8111−1.8093−1.7658
U.S. employment (nUS)−1.5281−1.5282−1.5308
Loss ECB0.22060.24120.2367
Loss ins’ government1.06221.11961.1399
Loss outs’ central bunk0.19620.21300.2142
Loss outs’ government1.47971.47861.4095
Loss Federal Reserve0.22060.22230.2214
Loss U.S. government1.06221.06261.0661
Note; In this table, and in the following ones, the values of the polity instruments and of the endogenous Variables should be multiplied by x, while the values of the loss functions should be multiplied by x2.

For both the ins and the outs we report the values of the main variables (CPI, employment, and the real exchange rate) and the value of the policymakersș loss function in equilibrium. We compare two situations: a = 0.5 and a = 0.75. How closely do these numbers reflect the possible situation in Europe? In an EMU that included only Germany, Austria, France, and the Benelux countries, a would be approximately equal to 0.5. A value of 0.75 would characterize an EMU that also included Italy and Spain, but left out the United Kingdom and the Nordic countries. Finally, we report the results for a = 1, that is, for the case where the dimension of the outs is negligible. This reference case is of interest because it describes a situation where the outs’ policy choices no longer affect the other economies and the European currency union and the United States face one another as two large symmetric entities.

When the outsiders are relatively small, and the trade-off is relatively more favorable, their central bank “rides” it more aggressively. In the equilibrium, prices are lower than in the case a = 0.5, but output is also lower, notwithstanding the relatively favorable trade-off (see Figure 2). Given our assumptions about the preferences of central banks and fiscal authorities, the outsiders’ central bank prefers a relatively large union (a= 0.75), while the opposite is true for the outsiders’ fiscal authority, which suffers because of the larger employment loss when a= 0.75.

We now turn to the insiders. Given the real appreciation engineered by the outsiders, the ECB responds with a tougher monetary contraction compared with what it would have done had it not imported additional inflation from the outs.16 Symmetrically to what happens in the outs, the ECB prefers a relatively small currency union, while ECOFIN would rather have a larger number of states in the union. Let us first try to understand why the ECB prefers a relatively small union.

As we have argued in the previous section, contrary to the outsiders, insiders face the same output-inflation trade-off, independent of the size of the currency union. Thus, in the ERM II regime, the insidersș central bank does not have the option of choosing a more favorable trade-off when expressing a preference over the size of the European currency union. For any value of a, the trade-off is always the same, and given that trade-off, the ECB can only respond to the other players’ policies by varying the degree of monetary contraction. When the outsiders are relatively small, even if they aggressively shift inflation abroad, the insiders’ effective real exchange rate does not depreciate very much, precisely because the outsiders are small.17 Faced with lower imported inflation, the insiders’central bank contracts less than for a = 0.5, and thus domestic producer prices remain relatively high.18 As a consequence, the insiders’ CPI also remains higher, and the central bank ends up being worse off. However, the insiders’ fiscal authority benefits from the milder contraction, and thus prefers a relatively larger currency union.

Finally we look at the situation in the United States. For a < 1, the strategic interaction between ins and outs inside Europe also affects the United States, whose effective real exchange rate depreciates.19 The Federal Reserve suffers from the strategic interaction inside Europe, the more so the larger is the currency union, for the same reason that induces the ECB to prefer a smaller union. When a = 0.75, the outs’ central bank is more aggressive not only toward the ECB, but also toward the Federal Reserve.20 Nonetheless, the Federal Reserve, analogously to the ECB, chooses a milder monetary contraction in that situation, and ends up suffering because of higher inflation. Hence, when the outs are nonnegligible, the Federal Reserve prefers to face a small currency union in Europe rather than a large one, even though a = 1 would be the best situation for both the ECB and the Federal Reserve. Analogously to ECOFIN, the U.S. government prefers a large rather than a small union, since the Federal Reserve’s monetary contraction is milder in the former case and the employment loss is smaller. Note that both the ins and the United States face the same employment-inflation trade-off as a consequence of the exchange rate regime in Europe, which presents the ins’ authorities with the European wide trade-off, independent of the size of the currency union. Consequently, the presence of nonnegligible outsiders—and the absence of intra-European monetary cooperation, as we shall see below—is crucial to have movements in the dollar/euro exchange rate in the framework we are examining. In fact, if the outsiders were negligible—or if they were nonnegligible but cross-country externalities in Europe were internalized—equal trade-offs would lead to equal equilibrium policies in the United States and in the currency union and there would be no changes in the dollar/euro exchange rate.21

The results presented in Table 1 allow us to make an interesting comparison with the analysis of Alesina and Grilli (1994). There the authors show that if EMU does not include all EU central banks from the start and monetary authorities in Europe have different degrees of inflation aversion, the initial insiders may not want the number of the ins to increase, even if a currency union encompassing all EU members would be the best option.

Something analogous happens in our model. If we think of the three values of a that we have considered as steps toward global monetary unification of Europe, if initially a = 0.5, subsequently, the ECB will not want to take the intermediate step toward a = 0.75, even if a = 1 would be the best solution. Interestingly, the Federal Reserve would share the ECB’s preferences and—in a sense—shortsightedness, contrary to the respective governments, which would always prefer a large currency union in Europe. We obtain the Alesina-Grilli result in a framework in which all central bankers have the same inflation aversion throughout the world. In our view, this shows that strategic interactions per se may matter at least as much as different degrees of inflation aversion in shaping policymakers’ incentives and behavior.

How do these results compare with the case of cooperation among central banks in Europe? We study this case because, according to some officials (but also according to Spaventa, 1996), the exchange rate arrangement (ERM II) that should link the ins and the outs after January 1, 1999, will entail—contrary to our assumption so far—some form of cooperation between the ECB and the central banks of the countries that will not join the currency union from the start. Their interpretation of how the new system could work is that of a cooperatively managed exchange rate system. The response of EU central banks to exogenous shocks would entail an EU-wide change in the money supply and, possibly, a cooperative realignment of intra-EU exchange rates.

We have computed the equilibrium of our model following an exogenous supply shock assuming that the ECB and the outsiders’ central bank cooperate with one another—though neither of them cooperates with the Federal Reserve. This is the only behavioral assumption that is changed with respect to the situation analyzed above. The first-order condition for the Federal Reserve choice is unchanged. Instead, the ECB and the outsiders’ central bank jointly minimize a weighted sum of their loss functions, with weights equal to a and (1 −a), respectively. This implies that the weight attached to each central bank’s loss function in the cooperative agreement is determined by the relative dimensions of the European economies. Although more complicated bargaining mechanisms could be envisaged, we believe that our simple assumption is not unrealistic. The first-order conditions to the central banksș problem are shown in Appendix II. The relevant results are summarized in Table 2. We limit ourselves to values of a strictly smaller than 1 because the ECB will have no incentives to cooperate with a region of negligible outsiders.

Table 2.Effects of a Cooperative ER M 11 with Fixed Taxes
Outs’ Size Small (a = 0.75)Outs’ Size Equal to Ins’ (a = 0.5)
Ins’ money (ml)−1.8423−1.8423
U.S. money (mUS)−1.8423−1.8423
Nominal outs/euro (e3)0.00000.0000
Real outs/euro (z3)0.00000.0000
Real dollar/euro (z1)0.00000.0000
Real dollar/outs (z2)0.00000.0000
Ins’CPI (ql)0,48050.4805
Outs’ CPI (qo)0,48050.4805
U.S. CPI (qUS)0.48050.4805
Ins’ employment (nl)−1.5281−1.5281
Outs’ employment (no)−1.5281−1.5281
U.S. employment (nUS)−1.5281−1.5281
Loss ECB0.22060.2206
Loss ins’ government1.06221.0622
Loss outs’ central bank0.22060.2206
Loss outs’ government1.06221.0622
Loss Federal Reserve0.22060.2206
Loss U.S. government1.06221.0622

The first, unsurprising, observation is that the cooperative response of central banks does not entail a change in the intra-EU exchange rate: the result is unsurprising because, as we have seen above, realignments are the result of the successful attempt by the outsiders to shift some of their inflation on the insiders—a behavior that is ruled out in a cooperative solution. Following the shock, the intra-EU exchange rate remains fixed, independent of the relative size of the ins and the outs.

The equilibrium values of the loss functions (of both fiscal and monetary authorities) are now independent of relative sizes—because size only matters when central banks play beggar-thy-neighbor policies. The loss of ECOFIN and the ECB is unambiguously lower than in the case of noncooperation. Note that, not surprisingly, in the case of monetary cooperation in Europe, all variables for the insiders and for the United States have the same values they had in the case of no cooperation when a = 1, so that monetary cooperation between ins and outs is equivalent to no cooperation when a = 1 from the perspective of the United States and the ins. The ECB’s gain from cooperation increases as the size of the union increases, where the gain is defined as the difference between the loss in the absence of cooperation and the loss under the cooperative ERM II regime. This result can be explained as follows. Smaller outs are more aggressive—which increases the ECB’s incentive to cooperate—but their impact on the ins’ economy is smaller—and this decreases the ECB’s interest in cooperation. However, in the absence of cooperation, it is precisely the smaller impact of the outs that induces the ECB to adopt a counterproductively looser policy when a= 7.5 Cooperation removes both the outs’ stronger aggressiveness as a increases, and the consequences of the ECB’s behavior. Hence, the potential gains for the ECB from cooperating with the outs’ central bank are larger in the large union case.

The situation, however, is different for the outsiders. The outs’ central bank is better off in the absence of cooperation—the more so the larger the currency union—because it is then allowed to appreciate vis-à-vis the insiders. (This is also true when the size of the outsiders is negligible (a = 1)22) The outsiders’ government, instead, always prefers monetary cooperation in Europe because it benefits from less contractionary monetary policies. Finally, monetary cooperation inside Europe benefits the Federal Reserve and the U.S. government—because intra-European cooperation removes the more aggressive behavior by the outs’ central bank, which induces a real depreciation of the dollar against the outsiders’ currency, and alleviates the deflationary bias associated with the lack of monetary cooperation in Europe.

Monetary and Fiscal Policy Interactions

As we have argued, the results obtained assuming that the fiscal authorities passively watch the interactions among central bankers characterize a currency union accompanied by a very tight Stability and Growth Pact that de facto prevents governments from using their fiscal instruments. In such a situation we have shown that a disagreement between the ECOFIN Council and the central bankers on the optimal size of the union may arise simply as a result of the lack of cooperation among EU monetary authorities, and thus quite independently of the consideration that—at least for some time—the ECB could be more credible in a relatively smaller and more homogeneous union.

Would such a disagreement disappear if governments were allowed to use fiscal policy to respond to exogenous shocks? The answer would almost certainly be positive if the two instruments (money and taxes) were set cooperatively. The ECB, however, will be independent, and throughout the EU member states are changing the statutes of their central banks so as to grant them more independence. The appropriate framework thus appears to be one where both inside and outside the currency union central banks and fiscal authorities do not cooperate. We have considered two situations: first, the case in which the ECB and the central banks of the outs cooperate among themselves but do not cooperate with the two European fiscal authorities—and neither with fiscal nor with monetary authorities in the United States, which also are assumed not to cooperate among themselves. We shall then consider the case where all six institutions act noncooperatively.

When fiscal authorities are active players in the game and the same behavioral assumptions of the previous case are maintained, the first-order conditions for the central banks’ problem remain unchanged. When these are combined with the conditions for the optimal choice of the fiscal instruments—see Appendix II—we have a system of six equations in six unknowns, whose solution is summarized in Table 3, together with the implied values of endogenous variables and loss functions. Now governments are no longer forced to “stay out of the game,” but are still worried about the costs that distortionary taxes impose on the economy.

Table 3.Effects of a Cooperative ERM II with Active Fiscal Policies
Rigid Fiscal Policies (ϑ= 0.2)Flexible Fiscal Policies (ϑ= 0.8)
Outs’ size small (a= 0.75)Outs’ size equal to ins’ (a = 0.5)Outs’ size small (a = 0.75)Outs’ size equal to ins’ (a= 0.5)
Ins’ money (ml)−1.4353−1.4034−.2204−0.1907
U.S. money (mUS)−1.4557−1.4340−0.2418−0.2221
Nominal outs/euro (e3)−0.0171−0.0084−0.0156−0.0074
Ins’ taxes (tl)−0.1956−-0.2227−0.7937−0.8203
U.S. taxes (tUS)−0.1670−0.1668−0.7605−0.7592
Outs’ taxes (to)−0.3000−0.2737−0.8888−0.8654
Real outs/euro (z3)0.04790.02340.04350.0206
Real dollar/euro (z1)−0.0209−0.0374−0.0235−0.0401
Real dollar/outs (z2)−0.0688−0,0608−0.0670−0,0607
Ins’ CPI (ql0.37980.36770.09320.0816
Outs’CPI (qo)0.36270.35940.07760.0742
U.S. CPI (qUS)0.39860.39790.11340.1132
Ins’ employment (nl)−1.2233−1.1845−0.3106−0.2728
Outs’ employment (no)−1.1070−1.1270−0.2049−0.2227
U.S. employment (nUS)−1.2678−1.2657−0.3607−0.3601
Loss ECB0.13970.13100.00870.0067
Loss ins’ government0.15140.14740.09800,0943
Loss outs’ central bank0.12050.12170.00480.0049
Loss outs’ government0.14760.14580.09430.0930
Loss Federal Reserve0.15190.15140.012290.01225
Loss U.S. government0.15740.15690,10520.1048

We present results for two different degrees of fiscal activism, the latter being lower the higher the weight governments attach to the volatility of distortionary taxes in their loss functions. In what follows, we focus on the case of limited fiscal activism, which is closer to the case of rigid fiscal policy studied above, and seems to be more realistic if we want to capture the relative rigidity of fiscal policy.23

Following a negative supply shock, all fiscal authorities cut taxes. This happens because, for the parameter values that we have chosen, a tax cut raises employment and output and contributes to stabilize prices.24 Note that the strategic interaction among European fiscal authorities induces the intra-European exchange rate to be adjusted even if the ECB and the outs’ central bank are cooperating with one another—thus deviating from the case in which fiscal policy did not operate (Table 2), which implied a constant intra-European real exchange rate. In all cases optimal policies produce a real depreciation of the outs’ currency against the euro (z3 positive); the magnitude of the real depreciation increases as the relative size of the currency union becomes larger. The point is that, like monetary policymakers have an incentive to export inflation abroad, fiscal authorities have an incentive to export unemployment. Central banks can achieve their goal by appreciating their currencies in real terms. Governments, instead, will export unemployment by trying to engineer a real depreciation. When the central banks are cooperating, only the second type of behavior is at work. Under the assumptions of our exercise, one can show that the ours’ government faces a more favorable employment-inflation trade-off than the ins’ government, and that the advantage of the outsiders increases as the size of the currency union becomes larger.25 Hence, consistent with the intuition that policymakers manage to engineer beggar-thy-neighbor policies when they face more favorable trade-offs than their neighbors, the outs’government manages to export unemployment to the ins via real depreciation, the more so the larger the currency union, as it is confirmed by the results on employment. This explains why the equilibrium value of the loss function of ECOFIN increases when the size of the currency union becomes larger.

What seems counterintuitive is that the ECB’s loss also increases with the size of the currency union, even if the real appreciation of the euro against the outs’ currency becomes larger. Looking at fiscal authorities’ behavior is helpfull, though. When a increases from 0.5 to 0.75, the outs’ government becomes more aggressive. But, like what happened in the case of only monetary interactions in the interplay between the ECB and the outs’ central bank, the ins’ government reacts by reducing the degree of its fiscal expansion. Because a tax cut stabilizes inflation in our exercises, this ends up inducing higher inflation in the ins’ economy even if the ECB goes for a sharper contraction when a= 0.75. As a consequence, in this case there is no disagreement between the ECB and ECOFIN on the desired size of the currency union, and both EMU authorities prefer the small union outcome.

The outs’ government is more aggressive when a= 0.75 and achieves a better stabilization of employment than when a = 0.5. Nonetheless, in order to do so, it pays the price that a more active fiscal policy implies in terms of higher loss.26 The employment gain is more than offset by the loss due to more volatile taxes, and the outs’ government is better off when the currency union is small. Instead, the outsiders’ central bank still prefers the large union outcome, even though inflation is higher in that situation. Even though central banks mainly care about inflation, the gain from a better stabilization of employment when a = 0.75 more than offsets the higher inflation loss. Note that the outs’ central bank and the ECB cooperatively realign the nominal exchange rate between the outs’ currency and the euro and let the former appreciate against the latter, the more so the larger the currency union. This is entirely consistent with the observed behavior of the real exchange rate: when the outs’ currency depreciates in real terms against the euro due to the fiscal authorities’ behavior, inflation in the outs’ economy tends to rise. This phenomenon is more relevant when the currency union is large, as the outs‐ government is more aggressive in that case. The ECB and the outs’ central bank are now jointly minimizing the respective loss functions, that is, they are jointly stabilizing the respective inflation rates. Thus, the optimal cooperative reaction to the inflationary effect on the outs’ economy of the real depreciation of their currency is given by a nominal appreciation intended to stabilize the outs’ CPI. The nominal appreciation of the outs’ currency against the euro is no longer a successful beggar-thy-neighbor policy allowed by the outs’ central bank’s more favorable trade-off. Rather, it is the optimal cooperative reaction of the two European central banks to the fiscal policymakers’ actions.

What is the role of the United States in this picture?

While intra-EU monetary interactions are cooperative, both monetary and fiscal interactions are noncooperative across the Atlantic. Even if we do not do it here, one can show that under the assumptions of this exercise, both European governments face more favorable trade-offs than the U.S. government, which always faces the same trade-off irrespective of the size of the currency union. Besides, the ins’ government’s trade-off approaches the U.S. government’ as a approaches 1, while the outs’ government’s trade-off becomes more and more favorable. The consequences of this can be seen in the pattern of transatlantic real exchange rates. The dollar appreciates against both European currencies, so that both European governments manage to export some unemployment to the United States. The real depreciation of the outs’ currency against the dollar increases with the size of the currency union, while the real depreciation of the euro decreases, consistent with what the changes in the trade-offs would suggest. In fact, we know that the outs’ government becomes more aggressive as a increases, while the ins’ government becomes less aggressive. The real appreciation of the dollar is harmful for the U.S. government, but helpful for the Federal Reserve, as it helps stabilize the U.S. CPI at the expense of the European ones. However, it is easy to check that the effective real appreciation of the dollar is larger when a = 0.5 than when a = 0.75. Thus, in an attempt at reducing the U.S. inflation, the Federal Reserve adopts a sharper contraction in the latter case. This contraction proves itself harmful for U.S. employment and contributes to make the U.S. government worse off when the currency union is large. Notwithstanding a tougher monetary policy, the U.S. CPI is higher when a = 0.75 and the Federal Reserve is worse off in that situation, as well.

Finally, we consider the case where none of the authorities cooperate. To compute the solution we go back to the situation in which there is no monetary cooperation, but we maintain an active role for fiscal policies. All players are active in the game and no distortion due to the externalities that they impose on one another is removed. Results are summarized in Table 4. All loss functions are uniformly lower than when fiscal policy cannot be used, even when we compare them with the case of cooperation among European central banks (Table 2), and even in the case where fiscal authorities can only move taxes by a little. The benefits stemming from the ability to use two instruments exceed the inefficiencies introduced by the absence of cooperation. As in the case of no fiscal policy response, the outsiders’ central bank is better off in the absence of cooperation than when European central banks coordinate their policies, as the noncooperative regime allows the outsiders’ monetary authority to strategically ride its more favorable trade-off. The ECB is correspondingly worse off. Both EMU authorities prefer the small union situation. Observe also that, when fiscal policy is used together with monetary policy, the Federal Reserve and the U.S. government are basically indifferent with respect to the presence or absence of intra-European monetary cooperation (see Tables 3 and 4). This result suggests that, when both policy instruments are available, flexible exchange rates between the United States and Europe provide a good degree of insulation to the U.S. economy with respect to changes in the way European monetary policies are conducted.27

Table 4.Effects of a N uncooperative E RM II with Active Fiscal Policies
Rigid Fiscal Policies (ϑ1 = 0.2)Flexible Fiscal Policies (ϑ1 = 0.8)
Outs’ size negligible (a= 1)Outs’ size small (a = 0.75)Outs’ size equal to ins’’ (a = 0.5)Outs’ size negligible (a= 1)Outs’ size small (a = 0.75)Outs’ size equal to ins’ (a = 0.5)
Ins’ money (ml)−1,5000−1.4408−1.4174−0.2838−0.2088−0.1771
U.S. money (mUS)−1.5000−1.4513−1.4280−0.2838−0.2371−0.2150
Nominal outs/euro (e3)−0.2122−0.1705−0.1217−0.0840−0.0605−0.0387
Ins’ taxes (tl)−0.1676−0.1976−0.2269−0.7631−0.7941−0.8187
U.S. taxes (tUS−0.1676−0.1671−0.1668−0.7631−0.7603;−0.7589;
Outs’taxes(to−0.3802−0.3431−03055−0.9673−0.9239−0.8892
Real outs/euro (z30.0002−0.0137−0.02360.06590.03940.0174
Real dollar/euro (z10.0000−0.0352−0.05860.0000−0.0275−0.0462
Real dollar/outs (z2)−0.0002−0.0215−0.0350−0.0659−0.0669−0.0636
Ins’ CPI (ql)0.39990.38860.37930.11380.09720.0855
Outs’ CPI (qo)0.18770.21810.25770.02980.03670.0470
U.S. CPI (qUS)0.39990.39860.39810.11380.11330.1132
Ins’ employment (nUS)−1.2719−1.2361−1.2065−0.3620−0.3093−0.2720
Outs’ employment (no)−1.2714−1.2694−1.2637−0.2022−0.2137−0.2290
U.S. employment (nUS)−1.2719−1.2679−1.2660−0.3620−0.3606−0.35997
Loss ECB0.15290.14440.13750.01240.00900.0070
Loss ins’ government0.15840.15470.15300.10590.09750.0939
Loss outs’ central bank0.09670.10200.10970.00240.00290.0036
Loss outs’ government0.20360.19260.18170.10830.10180.0980
Loss Federal Reserve0.15290.15190.15140.01240.01230.0122
Loss U.S. government0.15840.15740.15640.10590.10510.1048

Table 5 allows a comparison of the losses of ECOFIN and the ECB across the different policymaking regimes and summarizes some of the main results obtained thus far. When two instruments are available (money and taxes), both ECOFIN and the ECB are better off—even in the case where fiscal authorities move taxes by very little. More important, the conflict between the ECB and ECOFIN over the optimal size of the currency union disappears: for the reason suggested above both prefer a relatively smaller currency union.

Table 5.Comparison of Losses Under Alternative Policy Regimes
Loss to ECBLoss to Ins’ Government
Outs’ size small (a = 0.75)Outs’ size equal to ins’ (a = 0.5)Otits’ size small (a = 0.75)Ours’ size equal to ins’ (a = 0.5)
Noncooperative ERM II, fixed taxes0.24120.23671.11961.1399
Cooperative ERM II, fixed taxes0.22060.22061.06221.0622
Cooperative ERM II, active fiscal policies, rigid taxes0.13970.310.15140.1474
Cooperative ERM II, active fiscal policies, flexible taxes0.00870.00670.0980.0943
Noncooperarive ERM II, active fiscal policies, rigid taxes0.14440.13750.15470.1530
Noncooperarive ERM II, active fiscal policies, flexible taxes0.00900.00700.09750.0939

Closing Europe with Respect to the United States

In this section we ask to what extent our results on the choices of European policymakers depend on the presence of the United States—that is, were the two Western blocs completely isolated with respect to one another, would European policymakers’ preferences over the size of EMU differ? We study this possibility by closing the European economy with respect to the United States, so that no transatlantic policy spillovers exist and the only strategic interactions are those between the two groups of European countries.

Two assumptions are necessary in order to close the European economy with respect to the United States. The first one is that no transatlantic trade in goods happens, that is, that b = 0 in our model.28 However, the assumption of no trade in goods between Europe and the United States does not prevent U.S. (European) policies from having effects on the European (U.S.) economy. Trade in assets provides a second channel of transmission, which works through the uncovered interest parity conditions and the impact of nominal interest rate changes on the equilibrium in the money markets. A simple way to remove this channel of transmission is to assume that the demand for real money balances in each country is completely inelastic to the nominal interest rate. In this case, although capital mobility remains perfect, economic policy choices have no external effects across the Atlantic. The United States becomes a large economy totally unaffected by European policies, and insiders’ and outsiders’ choices affect only the two European economies.29

Computing the equilibrium for the noncooperative ERM II regime with fixed taxes leads to the results summarized in Table 6.30 The first thing to be observed is that the conflict of interest between ECOFIN and the ECB over the dimension of the currency union vanishes: both authorities are monotonically better off when the size of the union increases. In the case of the ECB, this is a consequence of the CPI being a decreasing function of a. As the currency union gets larger, the outsiders’ central bank becomes more aggressive—consistent with the results obtained above; however, imported inflation from the outs is less relevant for the ins than when the size of the union is relatively small, since imports from the outs decrease with their size.31 Consequently, the degree of monetary contraction by the ECB decreases as the union becomes larger, being equal to the Federal Reserve’s contraction when a = 1. However, in contrast to what happened in Table 1, the ins’ CPI decreases monotonically as the union gets larger, indicating that even if the monetary contraction becomes milder, the effect of lower imported inflation from the outs dominates that of less producer-price-index stabilization, thus allowing the ECB to achieve a better outcome in terms of the CPI.32 ECOFIN benefits from the milder monetary contraction when the union gets larger, as this directly implies a smaller employment loss.

Table 6.Effects of a Noncooperative ERM II with Fixed Taxes and a Closed Europe (b = 0, λ = 0)
Outs’ Size Negligible (a = 1)Outs’ Size Small (a = 0.75)Outs’ Size Equal to Ins’ (a = 0.5)
Ins’ money (ml)−1.4997−1.5398−1.5621
U S. money (mUS)−1.4997−1.4997−1.4997
Nominal outs/euro (e3)−0.2246−0.1953−0.1517
Real outs/euro (z3)−0.1231−0.1071−0.0831
Roal dollar/euro (10.0000−0.0199−0.0308
Real dollar/outs (z2)0.12310.08720.0523
Ins’CPI(ql)0.49010.50320.5105
Outs’ CPI(qo)0.26550.30790.3587
U.S. CPI(qUS)0.49010.49010.4901
Ins’ employment (nl)−1.4997−1.5398−1.5621
Outs’ employment (no)−1.7981−1.7994−1.7637
U.S. employment (nUS)−1.4997−1.4997−1.4997
Loss ECB0.22050.23250.2393
Loss ins’ government1.02411.07971.1111
Loss outs’ central bank0.19330.20450.2134
Loss outs’ government1.45851.46181.4062
Loss Federal Reserve0.22050.22050.2205
Loss U.S. government1.02411.02411.0241

We have observed above that our exercise does not exactly reproduce what would happen in a two-country model in which both channels of international transmission (goods and assets markets) matter. However, the results in Table 6 show that, in the framework of our three-country model, allowing for the presence of transatlantic monetary spillovers is crucial to obtain a conflict of interests between the ECB and the ECOFIN Council.33 In the following section we reintroduce transatlantic spillovers and we compare the results under the asymmetric intra-EU exchange rate regime analyzed thus far with those obtained under a symmetric regime. The discussion is based on the theoretical results summarized in the analytical framework and clarifies how the presence of the United States is important in determining the results presented in the section on monetary policy interactions.

As in Table 1, the outs’ central bank is always better off when a increases, thanks to its more aggressive behavior and the consequently lower CPI.34 In Table 1. however, the outs’ government monotonically preferred a small currency union in Europe rather than a large one. This was intuitively explained by the lower employment loss induced by less aggressive exchange rate policies. Here, instead, even though a = 0.5 remains the best outcome for the outs’ government, the situation in which the outsiders are only a small open economy (a = 1) is preferred to that of large union coupled with still significant outs (a= 0,75), Even though the outsiders’ central bank’s policy is more aggressive when a = 1, the milder monetary contraction by the ECB in that situation ends up inducing a smaller employment loss for the outs than when a = 0.75. On the contrary, when a = 0.5, the reduced aggressiveness of the outs’ central bank prevails on the more contractionary stance of the ECB in affecting the outsiders’ employment. Hence, under the assumptions of this exercise, one would expect the government of the outsiders to oppose the choice of a large rather than a small currency union, but to be in favor of a union encompassing all EU countries except a very small country rather than a large union with still significant outs.

The U.S. economy is obviously indifferent with respect to what happens in Europe. Note that both U.S. authorities are better off under the assumptions of this exercise than when transatlantic policy spillovers are present. If anything, this suggests that the U.S. government and the Federal Reserve may be increasingly in favor of a closure of the U.S. economy with respect to Europe, with this conclusion being stronger the smaller the size of the currency union. In the case in which a = 1, CPI inflation in the United States and in the currency union is higher than in the presence of transatlantic spillovers, but, even if the weight attached to employment in the central banks’ loss functions is much smaller than that attached to inflation, the employment gain from the closure more than offsets the increased inflation loss, making closure attractive not only for the United States but also for European authorities. The lower unemployment more than offsets the higher inflation loss for the Federal Reserve also when the outs are nonnegligible. The only case in which a policymaker prefers the situation in which transatlantic spillovers exist is given by the ECB when the currency union is small. In that case a higher inflation loss, when cross-Atlantic spillovers do not exist, more than offsets the employment gain and induces the ECB to prefer the situation in which policies have effects on both sides of the Atlantic.

Our results suggest a reason why policymakers in Europe and in the United States may find it attractive to adopt unmodeled policies aimed at removing transatlantic monetary spillovers. By closing the U.S. and the European economies with respect to one another, policymakers remove the source of the contractionary bias that affects noncooperative transatlantic monetary interactions when policies have effects on the other side of the ocean. The outcome—in terms of less contractionary policies—is similar to the one that would be achieved in the presence of transatlantic monetary cooperation.35 However, the implicit “desirability of two isolated Western blocs” that we find for most players must not be overstated. On the one hand, it may be easier for the involved authorities to improve their welfare by explicitly coordinating their policies rather than by working to close the respective economies. On the other hand, our model is an extremely simplified description of reality: even though under the assumptions of this section policies aimed at closing the two blocs with respect to one another would be mutually beneficial in most cases, in a more realistic setting, in which, for example, trade policy is explicitly considered, policies to close the U.S. and European blocs may well have welfare-decreasing effects also, due to the retaliations that aggressive trade policies are likely to cause.36 Besides, even without considering trade policy, it may be possible that, if fiscal policymakers are active players in the game, conflicts of interests among the players over the benefits from “closure” of the two Western blocs or transatlantic monetary cooperation become relevant.37

Symmetric Exchange Rate Regime in Europe

We now reintroduce transatlantic policy spillovers and compare the results obtained so far, under the assumption of an asymmetric monetary regime in Europe, with the case of flexible exchange rates: both the ECB and the central bank of the outsiders control the respective money supplies, and the intra-EU exchange rate is determined endogenously and left free to float. As mentioned in the introduction, such a regime is the relevant alternative to the policymakers’ plan to set up a new EMS linking insiders and outsiders.38

Results for the noncooperative monetary game when fiscal policies are fixed are summarized in Table 7. When we compare them with those reported in Table 1, for the corresponding case of an asymmetric monetary regime, we immediately see that once again—like when we had assumed away all transatlantic policy spillovers—the conflict of interests between the ECB and the ECOFIN Council disappears. Both authorities monotonically prefer a large union to a small one. ECOFIN’s preference for the large union is intuitively justified by the behavior of employment as a varies. Instead, the ECB turns out to be better off when inflation is relatively high than when it is lowest (a = 0.5).

Table 7.Effects of a Noncooperative Monetary Game with Fixed Taxes and a Symmetric Intra-EU Regime
Outs’ Size Negligible (a= 1)Outs’ Size Small (a = 0.75)Outs’ Size Equal to Ins’ (a = 0.5)
Ins’ money (m1)−1.8423−2.0955−2.2497
Outs’ money (mo)−2.2532−2,3023−2.2497
U.S. money (mUS)−1.8423−1.8619−1.8685
Real outs/euro (z3)−0.1168−0.05880.0000
Real dollar/euro (z1)0.0000−0.01380.3810
Real dollar/outs (z2)0.11680.07260.3810
Ins’ CPI (q1)0.48040.42720.3735
Outs’CPI(qo)0.26740.32000.3735
U.S. CPI (qUS)0.48040,48180.4823
Ins’ employment (n1)−1.5281−1.7195−1.8315
Outs’ employment (no)−1.8111−1.8620−1.8315
U.S. employment (nUS)−1.5281−1.5324−1.5339
Loss ECB0.22060.22300.2305
Loss ins’ government1.06231.33971.5164
Loss outs’ central bank0.19620.21940.2305
Loss outs’ government1.47971.56531.5164
Loss Federal Reserve0.22060.22190.2223
Loss U.S. government1.06231.06831.0704

In order to interpret the results for the alternative intra-EU regimes and to stress the role of the United States in our model, it is important to refer to the results summarized in the theoretical framework about the trade-offs facing the various policymakers. We know from the discussion in that section that, under the symmetric intra-EU exchange rate regime, when the outs’ size is nonnegligible (a < 1), the insiders face a more favorable trade-off than the United States. Nonetheless, the ECB ends up being worse off than the Federal Reserve, and this happens notwithstanding the fact that consumer price inflation is smaller in the monetary union than in the United States (q1 < qus). The crucial point is that the ECB, which has to cope with the impact of the outs’ central bank aggressive policy when a < 1, “rides” its more favorable trade-off with respect to the Federal Reserve’ much more aggressively, the more so the smaller a, in a successful attempt at exporting inflation to the United States via real appreciation of the euro against the dollar. However, in doing so, the ECB imposes an employment loss to the ins’ economy, which more than offsets the inflation gain, even if the weight attached to employment in the central banks’ loss functions is much smaller than that attached to inflation. As we move from the small currency union toward the situation in which the outs are negligible, the ins’ trade-off approaches that of the United States, and the incentive for the ECB to “ride” aggressively a more favorable trade-off with respect to the Federal Reserve’s is removed. Even if q1 rises, the ECB is made better off by the relevant employment gain.

When the intra-FU exchange rate regime was asymmetric and significant outs existed (Table 1), the ECB preferred a small union because, facing the same trade-off as the United States irrespective of the union’s size, the ins’ central bank had a smaller incentive to dump the outs’ aggressive behavior to the U.S. economy. As a consequence of this, the ECB’s monetary stance was always less contractionary than in Table 7 and, as we saw, when the union was large, the milder monetary contraction ended up destabilizing the PPI. With a symmetric exchange rate regime in Europe, the ECB prefers the large union for exactly the opposite reason: facing a more favorable trade-off than the United States, the ins’ monetary authority has a much stronger incentive to “ride” it aggressively in order to export to the United States the inflation it imports from the outs—the more so the smaller the currency union—but this has destabilizing consequences on employment that outweigh the inflation gain.39 Note that, as it should have been expected, the intra-European exchange rate regime is irrelevant when a = 1—in that case, the results in Tables 1 and 7 are identical. When the outsiders are negligible, the monetary arrangement governing intra-EU interactions is irrelevant also from the outs’ perspective because in that case the trade-offs faced by all authorities do not change across exchange rate regimes in Europe.

If the outs’ are non negligible and the intra-EU regime is symmetric, their central bank prefers a large rather than a small union—as shown in Table 1—because in that situation it achieves a better stabilization of the CPI, which offsets the employment loss due to a more contractionary stance. The central bank of the outsiders is more aggressive when a = 0.75 than when a = 1, even though its trade-off is better in the latter case. Still, the outs’ central bank achieves a better outcome in terms of the CPI when a = 1, and suffers a smaller employment loss than when the outs are nonnegligible. This is an example of a situation in which, faced with a more favorable trade-off, the policymaker refrains from “riding it” very aggressively, optimally trading control of inflation for employment stabilization. When the intra-EU exchange rate regime is symmetric and the outs’ size is negligible, the outs can thus achieve the same outcome as under the ERM II regime without having to increase the contractionary character of their policy with respect to the case a = 0.75.40 Note that when a = 0.75, the outs’ CPI is lower under the symmetric regime than under the asymmetric one, but this reduction in the CPI is achieved at the cost of a relevant employment loss, which ends up making the outs’ central bank worse off under the symmetric regime.

The previous observations make it clear why the government of the outsiders considers being a “small open economy” the best situation under a symmetric regime, but would choose the small union outcome rather than the large union. In Tables 1 and 6, a = 0.5 was the best possible outcome for the outs’ government, as explained above. As we go through our exercises, a =1 rises from the bottom to the top position in the ranking of the outs’ government’ preferences.41 The change between the ERM II regime with and without transatlantic externalities has been motivated in the previous section, whereas the difference between the asymmetric and the symmetric regimes with transatlantic spillovers is intuitively explained by the outs’ central bank behavior. With a = 0.5 there is no way for the central bank of the outsiders to actually export inflation to the ins, given the completely symmetric positions of the two European central banks. Thus, although the contractionary bias of noncooperative policies still exists, the monetary stance of the outs’ central bank is less contractionary than when a = 0.75, when the central bank can actually take advantage of a more favorable trade-off than the ins’ and does it aggressively. When a rises from 0.75 to 1, the outsiders’ employment-inflation trade-off improves further, as it happened under the asymmetric regime, but the central bank manages to achieve the same outcome as under that regime by means of a less contractionary policy than when a = 0.75 and only slightly more contractionary than when a = 0.5. Combined with the ECB’s and the Federal Reserve’s less contractionary policies—motivated by the fact that their trade-offs are now equal—this contributes to give the best employment outcome for the outs’ economy when a=1, contrary to what happened under the asymmetric regime.

Finally some remarks on the U.S. authorities. In contrast to the ECB, the Federal Reserve’s ranking of preferences when the intra-EU regime is symmetric is driven by the inflation outcome. The U.S. central bank considers a = 1 the best possible situation, but would prefer a large union over a small one when the outs are a significant entity. Hence, when a < 1, there is a preference reversal with respect to what happened when the ERM II regime was implemented in Europe. Again, the results summarized in the analytical framework help us understand what happens. Under the ERM II regime, both the ECB and the Federal Reserve always face identical trade-offs, and both suffer from the outs’ aggressive behavior when a = 0.75. When the intra-EU regime is asymmetric, the ECB does not have the possibility of exploiting a more favorable trade-off when the ins’ size is smaller than that of the United States. Instead, if the exchange rate regime in Europe is symmetric and the outs are nonnegligible, the ECB faces a more favorable trade-off than the Federal Reserve, the more so the smaller the currency union. As we have noted above, a consequence of this is that the ECB’s attitude toward the U.S. monetary authority in dumping on it the consequences of noncooperative policies within Europe is much more aggressive when a = 0.5 than when a = 0.75. Besides, as it happened under the ERM II regime, the outs’ central bank always faces a better trade-off than the Federal Reserve, and it faces the same tradeoff as the ECB’s when a = 0.5. Even though the trade-off faced by the outs’ worsens as a changes from 0.75 to 0.5, when the intra-EU exchange rate regime is symmetric, the overall monetary stance of Europe toward the United States—measured by [am1 + (1 − a)mo, where m1(mo) denotes money in the monetary union (outs)—is more aggressive when the currency union is small. When a = 0.75, the ECB’s policy is less contractionary, while the outs’ central bank is more aggressive. Combining these observations with the fact that, as the reader can check, the effect of m1 on qUS is larger when a = 0.75 and the impact of mo is larger when a = 0.5 explains why the U.S. central bank suffers a bigger loss in the latter situation.42

Thanks to the change in the Federal Reserve’s ranking of preferences, both the monetary authority and the U.S. government share the same ranking of preferences when the intra-European monetary arrangement is symmetric—and no cross-regime preference-reversal happens for the U.S. government. The monetary contraction implemented by the Federal Reserve is tougher the smaller the currency union, reacting to the policies implemented by the two European central banks. As a consequence, even though the Federal Reserve does not achieve the goal of having lowest inflation when the union is smallest, the employment loss increases as the size of the currency union decreases, and the U.S. government monotonically prefers a large union outcome rather than the small union case.

What would happen if the two European central banks cooperated with one another in the game in which only monetary policies are used actively? The answer is straightforward, as we know from the section on monetary policy interactions. Results for the U.S. and insiders’ authorities would coincide with those obtained in the absence of cooperation with a = 1, while the outs’ variables and losses would be “driven” to the same values as for the United States and the ins’ ones in the a = 1 with no cooperation case. No exchange rate change would be observed. Consequently, policymakers in the United States and in the insider countries would favor monetary cooperation inside Europe, analogously to what happened under the asymmetric exchange rate regime of the monetary policy interaction discussion. Instead, a conflict of interests would arise between the outsiders’ government and central bank if a = 0.75. The former would like European central banks to cooperate, as this would greatly reduce its unemployment loss. But the latter would be prevented from using the exchange rate as a strategic device to stabilize inflation, and would suffer from a larger loss.

Tables 8 and 9 describe the outcome when (limited) fiscal activism is introduced, in the case of a symmetric monetary regime with and without cooperation, respectively.

Table 8.Cooperative Monetary Game in EU, Limited Fiscal Activism, Symmetric Intra-EU Regime
Outs’ Size Small (a = 0.75)Outs’ Size Equal to Ins’ (a = 0.5)
Ins’ money (m1)−1.4471−1.4294
Outs’ money (mo)−1.446.1−1.4294
U.S. money (mUS)−1.4638−1.4519
Ins’ taxes (τ1)−0.1973−0.2263
Outs’ taxes (τo)−0.2553−0.2263
U.S. taxes (τUS)−0.1671−0.1670
Real outs/euro (z3)0.02650.0000
Real dollar/euro (z1)−0.0203−0.0358
Real dollar/outs (z2)−0.0468−0.0358
Ins’ CPI (q1)0.38240.3734
Outs’CPI(qo)0.37280,3734
U.S. CPI (qUS)0.39880,3985
Ins’ employment (n1)−1.2246−1.1877
Outs’ employment (no)−1.1602−1.1877
U.S. employment (nUS−1.2685−1.2674
Loss ECB0.14080,1333
Loss ins’ government0.15200.1488
Loss outs’ central bank0.12990.1333
Loss outs’ government0.14860.1488
Loss Federal Reserve0.15200.1518
Loss U.S. government0.15760.1573
Table 9.Noncooperative Monetary Game, Limited Fiscal Activism, Symmetric Intra-EU Regime
Outs’ Size Negligible (a= 1)Outs’ Size Small (a = 0.75)Ours’ Size Equal to Ins’ (a = 0.5)
Ins’ money (m1)−1.5000−1.6083−1.6941
Outs’ money (mo)−1.8401−1.7721−1.6941
U.S. money (mUS)−1.5000−1.4587−1.4443
Ins’ taxes (τ1)−0.1676−0.2148−0.2588
Outs’ taxes (τo)−0.3.100−0.2981−0.2588
U.S. taxes (τUS)−0.1676−0.1673−0.1671
Real outs/euro (z3)−0.0228−0.00870.0000
Real dollar/euro (z1)0.0000−0.0218−0.0268
Real dollar/outs (z2)0.0228−0.0131−0.0268
Ins’CPI(q1)0.39990.33320.2789
Outs’CPI(qo)0.19600.23410.2789
U.S.CPI(qUS)0.39990.39910.3988
Ins’ employment (n1)−1.2719−1.3413−1.3675
Outs’ employment (no)−1.3272−1.3623−1.3675
U.S. employment (nUS)−1.2719−1.2695−1.2685
Loss ECB0.15290.13990.1285
Loss ins’ government0.15840.18150.1959
Loss outs’ central bank0.10530.11750.1285
Loss outs’ government0.20250.20310.1959
Loss Federal Reserve0.15290.15230.1520
Loss U.S. government0.15840.15780.1576

As in the section on monetary and fiscal policy interactions, adding active fiscal policies as stabilizing devices against the impact of the shock has a welfare improving effect for all players. In the case of monetary cooperation, since the intra-EU exchange rate regime is symmetric, if a = 0.5, even if fiscal externalities are not internalized, the euro-outs exchange rate does not move because optimal policies are identical for both the ins’ and the outs’ policymakers. The exchange rate between insiders and outsiders does move when a = 0.75, in which case optimal policies differ. Insiders’ authorities prefer a small rather than a large union and the same is true for U.S. policymakers. Instead, the outsiders’ central bank and government both prefer a large rather than a small union. These results are analogous to those presented in Table 3 for the case of an asymmetric regime in Europe. We leave it to the reader to interpret them on the basis of the intuitions provided throughout the paper.

All policymakers are better off when governments can use fiscal policy to react to exogenous shocks, even in the absence of monetary cooperation (Table 9). In this case we observe again a conflict of interests between ECOFIN and the ECB on the desired size of the European currency union: the ECB prefers a small union, while ECOFIN prefers a large one. This is different from what happened under the ERM II regime in Europe (Table 4), in which case both the insiders’ authorities preferred the small union outcome. The difference in the ranking of ECOFIN’s preferences with respect to Table 4 is due to the fact that, under the symmetric regime, the employment loss increases as the size of the union decreases, while the opposite happened under the ERM II regime. When a = 0.5 and the exchange rate regime is symmetric, the European authorities face identical employment-inflation trade-offs. As the size of the outs increases from a = 1 to a = 0.5, the trade-off facing the ECB becomes steeper. The symmetry between ins and outs that is achieved when a = 0.5 induces the ECB to behave more aggressively, in contrast to what happened in the ERM II case of Table 4, with contractionary consequences on the ins’ economy. The small union case represents the best case for the outs’ government, whereas the central bank monotonically prefers a large union. Both U.S. policymakers favor the small union case over the large one. Again, we leave it to the reader to go deeper into the interpretation of the results presented above.43

Conclusions

In this paper we have addressed the issue of the optimal size of the European currency union, concentrating our attention on the effects of changes in the size of EMU on the interactions among fiscal and monetary authorities in Europe, and between Europe and the rest of the world. We have argued that explicitly considering the presence of the rest of the world—which we have called “the United States”—is important in understanding policymakers’ incentives and behavior. In our analysis, we have always maintained the same assumptions about the way European and U.S. authorities interact with each other, namely, noncooperatively and under a flexible exchange rate regime.44

Consider the institutional setup that, we believe, will most likely characterize the future working of EMU, at least initially: frozen fiscal policies and noncooperative monetary policies under an ERM II regime in Europe. In this setup, the view that central bankers would prefer the currency union to be relatively small, while ECOFIN would prefer it to be relatively larger, is confirmed by our analysis—provided the size of the outsiders is nonnegligible. The only way to obtain an agreement between ECOFIN and the ECB on the desired size of the currency union is either by convincing the central banks of the ins and outs to cooperate (in which case the size of the currency union becomes irrelevant), or by allowing governments to actively use fiscal policy in response to exogenous shocks. But the outsider central bank stands to lose from cooperating with the ECB—independent of the degree of fiscal policy activism and of the size of the outsiders relative to the insiders. Moreover, it always prefers the currency union to be relatively large because this is the situation in which it can best exploit its ability to export inflation to the insiders by aggressively “riding” the more favorable output-inflation trade-off it faces. This suggests a potentially important reason (which may run against different arguments in favor of joining the single currency) why some states may be unwilling to join the currency union and why, once they are out, their central banks may be unwilling to enter a cooperative agreement with the ECB.

Table 10 shows the preference rankings of the various players over the size of the European currency union for the case of noncooperative monetary interactions with fixed taxes in the three different environments that we have analyzed: ERM II, closed Western blocs, and flexible exchange rates in Europe. In the table, a is omitted to save on notation, and ≻ denotes “preferred to,” whereas ≈ denotes “indifferent to.”

Table 10.Summary of Preferenee Rankings
ECBIns’ Government
Noncooperative ERM II1 ≻ 0.5 ≻ 0.751 ≻ 0.75 ≻ 0.5
Closed Western blocs1 ≻ 0.75 ≻ 0.51 ≻0.75 ≻0.5
Symmetric regime in Europe1 ≻ 0.75 ≻ 0.51 ≻0.75 ≻0.5
Outs’ Central Bank(Outs’ Government
Noncooperative ERM II1 ≻ 0.75 ≻ 0.50.5 ≻ 0.75 ≻ 1
Closed Western blocs1 ≻ 0.75 ≻ 0.50.5 ≻ 1 ≻ 0.75
Symmetric regime in Europe1 ≻ 0.75 ≻ 0.51 ≻ 0.5 ≻ 0.75
Federal ReserveU.S.. Government
Noncooperative ERM II1 ≻ 0.5 ≻ 0.751 ≻ 0.75 ≻ 0.5
Closed Western blocs1 ≈ 0.75 ≈ 0.51 ≈0.75 ≈ 0.5
Symmetric regime in Europe1 ≻ 0.75 ≻ 0.51 ≻ 0.75 ≻ 0.5
Note; In this table, a is omitted, and ≻ denotes “preferred to,” whereas ≈ denotes “indifferent to”

For almost all players and in all the three different settings that we have analyzed, the situation in which the currency union in Europe encompasses the whole EU except for a small entity is the best outcome. This result parallels that obtained by Alesina and Grilli (1994), though in a different model and under different assumptions. The one authority that does not always prefer that outcome is the outs’ government, which ranks a = 1 first only when the exchange rate regime in Europe is symmetric for the reasons discussed above. Note, however, that preference rankings between a = 0.5 and a = 0.75 vary across authorities.

Potential conflicts of interests can arise within one country over the optimal size of the currency union. Not only do we find a conflict between ECOFIN and the ECB under the ERM II regime in Europe, but also, while the central bank of the outsiders always prefers a = 0.75 to a = 0.5, the opposite holds for the outs’ government. Given a significant size for the outs, the latter would always choose a small rather than a large currency union. Also, the Federal Reserve and the U.S. government may disagree over the optimal size of the European currency union if an EMS-style regime were to be implemented in Europe, with the Federal Reserve preferring a small union and the United States a large one if a < 1. Nonetheless, even if U.S. policymakers will be interested spectators of what happens in Europe and transatlantic interactions do affect all policymakers’ welfare, it does not seem likely that European policymakers will condition their choices about the size of the currency union in 1998 and in the following years on U.S. authorities’ preferences.

As our model suggests, in 1998, when the initial size of the currency union is to be decided, strategic interactions among players could justify considerable strain in the choice process. This may be true irrespective of monetary and fiscal policymakers having different preferences across countries. The outcome will depend on the relative bargaining power of the various involved policymakers as well as on other political considerations that our model does not capture. The institutional framework within which the policymakers interact will play a crucial role in this process.

Note that the outs’ government always prefers a small rather than a large union, when a is not 1. This observation suggests that, if we explicitly allow for a multiplicity of outsiders’ governments, rather than a single one that has “preferences over the size of its country,” in our framework, all of them would want to stay out of the union when it comes to life, because the small union outcome is more attractive to them. As a consequence, in the situation we have analyzed, it would be hard to find outs’ governments actually willing to join the union either from its beginning or after that time. Resistance by outsiders’ governments to join could lead to an initially relatively small currency union, thus meeting the preferences of the ECB under an ERM II regime.45 The intuition cannot be overstated, however. The conclusion of our model is based on the assumption that the outs act as a unified bloc, which is analogous to assuming that all outs’central banks cooperate with each other and all outs’governments do the same. Explicitly considering the possibility of noncooperative strategic interactions within the group of the outsiders may significantly affect the results, and would allow a better analysis of the problem.46 We leave these issues for further research on the topic.

The previous observations lead us naturally to a second set of remarks. After the initial size of the currency union has been chosen, the natural evolution of the union itself as dictated by the Maastricht Treaty would be its enlargement over time to cover the whole EU. Our result that a = 1 is the best outcome for most players—including the United States!—lends support to the advocates of the desirability of such outcome. Suppose that potential conflicts between the ECB and the ECOFIN Council either are not an issue or are resolved in favor of the enlargement option.47 Still, the results of our simulations suggest that the remaining outs’ governments may not find joining the union attractive.

The analysis of our paper assumes that all players approach 1998 and the subsequent period starting from equal initial conditions, their economies being in equilibrium, and addresses the topic from the limited perspective of the optimal reactions to a supply side disturbance. Reality is much more complicated, though. In 1998 European countries will be characterized by different economic situations. Outs may be outs either because they are not attracted by the perspective of joining the union or because they are not accepted in it, or for both reasons. It is plausible that most outsiders’ economics will be classified as relatively weak or plagued by significant disequilibria. If their governments (or their central banks) do not have strong incentives to join the European currency union—and our model suggests potential reasons why this could happen—the process of enlargement of the union envisioned in the Maastricht Treaty could prove itself slower and more conflictive than optimists normally argue.

One of the interpretations of how the process of European integration in different fields has evolved over time has to do with the idea of positive spillovers from the economic to the social and political arena, with integration starting in the economic field, deepening, and then being extended to the other areas. The facts of the past lend support to this idea. But if the preferences of the outs’ governments were to become an obstacle, this could break down the whole process when the biggest obstacle of the past—German resistance and fear—seems to be overcome. The obvious objection is that the analysis of this paper overlooks important political economy arguments that would explain why the outsiders are indeed likely to eventually join the union.48 The process of integration in Europe is indeed driven mainly by political reasons, which have their roots in historical events. A failure in the process of Western European integration before enlargement to the Eastern European countries, would probably lead to Germany—and not the EU—deepening its integration with the latter countries, facilitated by historical linkages and economic interdependencies. As a consequence of the potential economic strength of this bloc, Mediterranean countries, but also the United Kingdom, would bear the risk of living in a continent that “will dance to the tune of Germany, and where other countries will find their views much more difficult to be heard.” Our model cannot capture these aspects of the whole process, but it suggests reasons, other than cross-country differences in preferences, why different policymakers may have different incentives in approaching EMU. Combining these economic incentives with political considerations in a unified framework would provide a comprehensive analysis of the problem—but this is well beyond the aim of this paper and it is also left for future work.

Finally, there is another dimension of the choices that the various policymakers will face by 1998 that deserves attention in this conclusion: for a given initial size of the currency union, what will be the optimal intra-European monetary arrangement? Our analysis has been mainly focused on the choice of the optimal size of the European currency union, but the results that we have obtained allow tentative answers to this other question. In order to give an example, we focus our attention on the case of fixed fiscal policies and no cooperation, which, as we have repeatedly argued, seems to be the most likely one. Table 11 summarizes the authorities’ preference rankings in the choice between a noncooperative ERM II regime (denoted by A) and the noncooperative flexible exchange rate regime (denoted by B). The rankings are based on the results reported in Table 1 and in Table 7.

Table 11.Preference Rankings (over Exchange Rate Regimes in Europe with No Cooperation
Outs’ Size Negligible (a = 1)Outs’ Size Small (a = 0.75)Outs’ Size Equal to Ins’ (a = 0.5)
ECBA ≈ BB ≻ AB ≻ A
Ins’ governmentA ≈ BA ≻ BA ≻ B
Outs’central bankA ≈ BA ≻ BA ≻ B
Outs’ governmentA ≈ BA ≻ BA ≻ B
Federal ReserveA ≈ BB ≻ AA ≻ B
U.S. governmentA ≈ BA ≻ BA ≻ B
Note: A stands for ERM II regime, whereas B denotes the symmetric flexible exchange rate regime.

When the European currency union includes all countries except for a small open economy, all players are indifferent as to the exchange rate regime that prevails in Europe, which is intuitively justified by the absence of any impact of the outs’ policy choices on the rest of the world. But when the outsiders are nonnegligible, in most cases the ERM II regime turns out to be preferred to the flexible exchange rate regime. This is justified by the results that we have discussed in the previous sections. Controlling the exchange rate allows the outsiders’ central bank to achieve a better outcome than would be achieved by controlling the money supply. Under the asymmetric regime, the employment loss is smaller, and the outs’ government is consequently better off. Therefore, at least if fixed fiscal policies and no cooperation represent a likely scenario, the results of our exercise suggest that the outs’ authorities will favor the adoption of an EMS-style regime over that of a flexible rate arrangement. Instead, we observe a conflict of interests between the ECB and ECOFIN over what regime should be implemented. As could have been expected on the basis of the results and intuitions discussed above, the ECB would like a flexible exchange rate regime to be adopted since this would allow it to achieve a significantly better inflation outcome by depriving the outs’ central bank of control over the exchange rate. Nonetheless, this would come at the cost of higher employment losses, which induce ECOFIN to prefer the managed exchange rate regime.

Although the ERM II alternative has prevailed as the future intra-EU regime, this further source of conflict among different policymakers over the optimal features of the European currency union is not unlikely.49 Reasons of brevity prevent us from presenting analogous tables for the other policymaking regimes we have considered. The interested reader can easily reconstruct them from the material presented above and interpret the results using the tools and intuitions discussed in the paper. Nonetheless, Tables 10 and 11 are enough to drive home an important point of this paper: as 1998 approaches, conflicts of interests between policymakers are likely to arise on the different issues they face. We have discussed above the problems that may be caused by disagreements over the optimal size of the union. But also, analyses of alternative monetary arrangements between the ins and the outs in the post-EMU era should take into account the possibility of conflicts of interests among policymakers within one group or the other as well as across countries. This would increase the realism of the discussions and could improve the reliability of any normative suggestion based on them. Some ways to deal with the conflicts to which we have referred—and with the many others that we have probably overlooked—will have to be found to ensure a proper functioning to the European integration process. The way institutions are designed and political developments will play a crucial role with respect to these problems.

One more observation is in order before closing this paper. In all our simulations we have seen that some degree of fiscal activism makes all authorities better off with respect to the situation in which only monetary policy is used to react against the consequences of the supply side shock. This result may be interpreted as an argument against the rigid application of a Stability and Growth Pact in Europe. However, the way fiscal policy is modeled in our paper is extremely simplified. Indeed, if fiscal stability is interpreted as referring to the behavior of deficits and debts, active budget-balancing fiscal policies as those considered in the paper are not inconsistent with a “fiscal stability pact” and some flexibility of fiscal policy would be welfare improving, as the results of our simulations suggest. To provide a more thorough analysis of the role of fiscal policy as an active instrument available to policymakers and of the issue of fiscal discipline, extending the model to a multiperiod framework in which deficits and debt accumulation are allowed would be necessary. This is another line along which we believe it is worth extending our research in the future.

Appendix I

A Three-Country Model of Strategic Policy Interactions

The world is divided into three countries: the United States, the ins, and the outs. The two European goods are imperfect substitutes for the U.S. good and for one another. In the absence of disturbances, Europe and the United States are symmetric to one another.50

Output in each country (yi,J = US, /, 0) is an increasing function of employment (ni) and a decreasing function of a world productivity disturbance (x):

where (1 − α), with 0 < α < 1, is the same in all countries. The productivity disturbance is identically and independently distributed with zero mean.

The labor demand of firms is implicit in the following profit maximization condition, where τ indicates the rate of taxation of total revenues:51

Real wages are nominal wages (wj minus product prices (pj).

Consumer price indexes (qj) are weighted averages of the prices of U.S., ins’, and outs’ goods. As shown in Figure 1, American consumers allocate a fraction b of their spending to European goods (a to the good produced by the ins, and (1 − a) to that produced by the outs) so the U.S. CPI is

where exchange rates e1 and e2 are the dollar prices of the euro and of the currency of the outs, respectively, and z1 and z2 are the dollar-euro and dollar-outs real exchange rates:

European consumers allocate a fraction bof their spending to the U.S. good, and divide the rest of their spending between the two European goods, a to the ins’ good and (1 − a) to the outs’. The European CPIs are

The outs-euro real exchange rate is z3 = z1z2.

Demand for all goods increases with output. Residents of each country increase their spending by the same fraction (0 < ε < 1) of an increase in output. The marginal propensity to spend is equal to the average propensity to spend for all goods for residents of all countries.52

An increase in ex ante real interest rates (rj) reduces the demand for all goods: residents of each country decrease spending by the same amount (0 < ν < 1) for each percentage point increase in the ex ante real interest rate facing them.

Equilibrium conditions for the three goods are

Ex ante real interest rates are53

where iUS, il, and io are nominal interest rates on bonds denominated in dollars, euros, and the outs’ currency, respectively, and E(•+1) indicates the expected value of a variable tomorrow on the basis of information available today. Real depreciation of a currency shifts world demand toward that country’s good.54 We also assume that a random disturbance (u), identically and independently distributed with zero mean, can shift the world demand from European goods to U.S. goods.

The government budget constraints are given by

Government spending falls entirely on goods (transfers are considered negative taxes and are included in τ); gj defines the ratio Gj/PjYj and government j’s budget constraint is Gj = τjPjYj. In equations (A6) we have implicitly assumed that the international allocation of governments’ consumption resembles that of private consumption, with the parameter η replacing b and η presumably not greater than b.

There are three stocks of bonds, each denominated in one of the three currencies. Residents of each country, who regard bonds denominated in all three currencies as perfect substitutes, hold positive amounts of all kinds of bonds only when their expected returns, measured in a common currency, are equal:

In contrast, each country’s currency is held only by its residents. Demands for real money balances are given by

Making use of the production functions, firms’ labor demands, and the demands for real money balances, we obtain

At the end of the previous period, competitive unions and firms sign contracts specifying nominal wages for the current period. Unions choose nominal wages to minimize expected deviations of employment and the real wage from zero disturbance equilibrium values.55 To focus on international interactions, we assume that no time inconsistency problem exists and that all random disturbances are unexpected. The endogenous variables are shown in Ghironi and Giavazzi (1997c) to be linear functions of the policy instruments and of the shocks. Hence, expected values of both authorities’ instruments and endogenous variables coincide with their no-disturbance equilibrium values, that is, zero. It will become apparent that zero values for the authorities’ instruments are optimal in the absence of disturbances. Thus the rational wage-setting rule turns out to be

Using this rule and equations (Al), (A10), and (A11), we obtain

Equations (A1)(A14) comprise the structural model. Next, we present the policymakers’ preferences and the main reduced-form equations.

Each central bank chooses its instrument to minimize:

where γ1 measures the weight attached to inflation relative to employment by central banks. The ECB and the Federal Reserve control the respective money supplies, and the exchange rate between the euro and the dollar is flexible. Within Europe we consider two different monetary regimes: an asymmetric regime, in which the ECB sets the money supply, while the outsiders’ central bank sets the value of e3 = e1e2, the nominal exchange rate between the outsiders’ currency and the euro; and a symmetric regime, in which both the ECB and the outsiders’ central bank set the money supply, and the intra-European exchange rate is floating.

When it plays actively, the government in each country chooses taxes to minimize a quadratic loss function that depends on the deviations of inflation, employment, and taxation from their equilibrium values. We assume that the volatility of taxation represents a cost for fiscal authorities. As explained in the text, this could be motivated by the presence of convex distortions, but it could also capture the idea that fiscal policy is difficult to fine-tune relative to monetary policy. Thus, country j’s government minimizes

When ϑ1 is low, the degree of fiscal activism is reduced and the government is forced (e.g., by unmodeled institutional and political constraints) not to use its instrument aggressively in order to act on inflation and employment. The parameter ϑ2,. measures the weight attached to inflation relative to employment by the fiscal authorities. We assume that, in the limiting case ϑ1 = 0, in which governments do not play actively and taxes are zero, governments still care about inflation and employment: their welfare is thus evaluated according to the criterion

Endogenous variables in each country are linear functions of the policy instruments and of the disturbances.56 This implies that when x = u = 0, zero values of the instruments ensure zero losses for all authorities, and proves the rationality of static expectations under the assumption that disturbances have zero mean.

We next show the reduced-form equations for employment and the CPI in each country, in the two European monetary regimes. In the equations that follow, all parameters indexed by a number are functions of a, the parameter that defines the size of the currency union. When a < 1, the following are the reduced forms for employment in the three countries.

  • Managed exchange rates inside Europe:

    and the following relations hold among the reduced-form parameters:

  • Flexible exchange rates inside Europe:

    and the following relations hold among the reduced-form parameters:

    57

When a = 1, the outsiders are a “small open economy” that is affected by the United States’ and the insiders’ policies but whose choices have no effect abroad; equations (A18) and (A18′) reduce to the following.

  • Managed exchange rates inside Europe:

  • Flexible exchange rates inside Europe:

Similarly, when a < 1, reduced forms for the CPIs are the following.

  • Managed exchange rates inside Europe:

    and Γ1, + Γ2 = Γ, E1, + E2 = E. Note that the insiders’ fiscal policy has the same impact on both the insiders’ and the outsiders’ CPIs, and the same is true for the outsiders’ fiscal policy. This can be seen observing that, subtracting qo from ql, one obtains qlo = −(M2 +M3e3 independent of τ. Recalling the expressions for qo and ql in terms of PPIs and real exchange rates (equations (A5)) and using the definitions of z1 and z2, it is possible to show that it actually has to be the case that qlqo = − e3 that is, that it has to be M2 + M3 = l.58

  • Flexible exchange rates inside Europe;

    and B1 + B2 = B, Γ1, + Γ2. = Γ, A,1A2, = A3, − A4 = A, E1, + E2 = E3 + E4 = E.59

As a consequence of the change in the intra-European exchange rate regime, it is no longer the case that the insiders’ fiscal policy has the same impact on both the insiders’ and the outsiders’ CPIs, and that the same holds for the outsiders’ fiscal policy.

If the outsiders are very small (a = 1), the previous reduced-form equations become

  • Managed exchange rates inside Europe:

    Note that, while outsiders’ the fiscal policy still affects no when a = 1, it no longer affects qo. Also, in this situation, movements e3 have a one-to-one impact on the insiders’ CPI.60

  • Flexible exchange rates inside Europe:

When the European exchange rate regime is symmetric, it is no longer the case that the outsiders’ fiscal policy has no impact on qo when the outsiders are very small.

The reduced-form parameters in the preceding equations are functions of the structural parameters. Their signs are often ambiguous, since they depend on the interaction of several channels of transmission. In equations (A18, A18′)(A21, A21′), all the coefficients are assumed to be positive; the signs are those implied by our assumptions on the value of the structural parameters, which are chosen to provide clear-cut conclusions in the response to a supply shock. Recall also that the values of the reduced-form parameters that are not indexed by a number do not change for given values of the other structural parameters of the model as a does.61

The values we assign to the structural parameters are a = 0.34, δ = 0.8, ε = 0.8, ν = 0.4, λ = 0.6, b = η = 0.1. Though arbitrary, these values can be defended based on the empirical evidence. (1 − α), for instance, corresponds to the share of labor in a Cobb-Douglas production function—and a share of capital equal to one-third is not unrealistic. ε is the marginal propensity to consume out of disposable income—a value of 0.8 does not seem far from reality, b measures the extent of transatlantic trade, which is fairly small if compared to intra-European trade. Similar justifications can be given for the other parameter values. It could be argued that the value of λ is relatively high for a short-run oriented model, although 0.5 would be the value suggested by a standard Baumol-Tobin model of money demand determination. It turns out that choosing a lower value for λ would not change the nature of fiscal policy in the model, budget-balancing tax cuts being still expansionary for smaller λ.62 Our parameter choice has the advantage of allowing a significant impact of the supply shock on employment and a nonnegligible external effect of domestic economic policies on foreign employment under flexible exchange rates.63

We consider three alternative values for a: 0.5, 0.75, and 1. Approximate values of the reduced-form parameters, which are invariant with respect to a, are given in Table A1. We assume that there is no demand disturbance (u = 0) and therefore we omit the values of K and Φ. Table A2 shows approximate values of the reduced-form parameters that change with the size of the currency union. As noted above, these parameters differ across exchange rate regimes. Numerical values of the employment-inflation trade-offs facing insiders and outsiders under alternative exchange-rate regimes in Europe are displayed in Table A3. Finally, we make the following assumptions about policymakers’ preferences. Three alternative values of ϑ1, are considered (0, 0.2, 0.8), the degree of fiscal activism being an increasing function of that parameter. For given flexibility of fiscal policy, we make the realistic assumption that central banks care much more about CPI inflation than about employment (γ1 = 0.9), while the opposite is true for fiscal authorities (ϑ2 = 0.1).

Table A1.Reduced-Form Parameters independent of a
A = 0.26B = 0.02E = 0.75Γ = 0.22Σ = 0.93
Λ = 0.75Ω = 0.56Θ = 0.03Ψ = 0.49H = 0.21
Table A2.Reduced-Form Parameters Whose Value Depends on a
Managed Exchange Rates Inside Europe
a = 0.5E1 = 0.42E2 = 0.33Γ1 = 0.11Γ2 = 0.11M1 = 0.02M2 = 0.25M3 = 0.75
ʩ1 = 0.82Ω2 = 0.26Ω3 = 1.07Ω4 = 0.51Ψ1 = 0.24Ψ2 = 0.25Δ1 = 0.03Δ2 = 0.06Δ3 = 1.38
a = 0.75E1 = 0.59E2 = 0.16Γ1 = 0.16Γ2 = 0.06M1 = 0.01M2 =0.12M3 = 0.88
Ω1 = 0.69Ω2 = 0.13Ω3 = 1.20Ω4 = 0.64Ψ1 = 0.36Ψ2 = 0.13Δ1 = 0.02Δ1 = 0.03Δ1 = 1.36
a= 1Ω3 = 1.33Ω4 = 0.77Δ4 = 1.33
Flexible Exchange Rates Inside Europe1
a = 0.5A1 = 0.39A2 = 0.13A3 = 0.39A4 = 0.13B1 = 0.01B2 = 0.01
E1 = 0.46E2 = 0.39E3 = 0.46E4 = 0.29Γ1 = 0.11Γ2 = 0.11
Λ1 = 0.72Λ2 = 0.03Λ3 = 0.72Λ4 = 0.03Θ1 = 0.02Θ2 = 0.02
Ω1 = 0.83Ω2 = 0.27Ω3 = 0.83Ω4= 0.27Ψ1 = 0.25Ψ2 = 0.25
a = 0.75A1 = 0.33A2 = 0.07A3 = 0.45A4 = 0.19B1 = 0.02B2 = 0.01
E1 = 0.61E2 = 0.14E3 = 0.32E4 = 0.43Γ1 = 0.16Γ2 = 0.06
Λ1 = 0.74Λ2 = 0.015Λ3 = 0.71Λ4 = 0.05Θ1 = 0.02Θ2 = 0.01
Ω1 = 0.69Ω2 = 0.13Ω3 = 0.97Ω4 = 0.41Ψ1 = 0.36Ψ2 = 0.13
a = 1A3 = 0.52A4 = 0.26E3 = 0.17E4 = 0.58
Λ3 = 0.69Λ4 =0.06Ω3 = 1.1Ω4 = 0.54
Table A3.Employment-Inflation Tradeoffs Facing Outsiders and Insiders
OutsIns
a = 0.5
Flexible exchange rates0.544860.54486
ERM II0.544860.35537
a = 0.75
Flexible exchange rates0.646540.44722
ERM II0.646540.35337
a= 1
Flexible exchange rates0.75250.35337
ERM II0.75250.35337
Appendix II

First-Order Conditions for the Stabilization Game

  • Noncooperative ERM II, fixed taxes.

  • Cooperative ERM II, fixed taxes.

    mland e3 are chosen so that 8

    The condition for the optimal choice of mUS is unchanged.

  • Cooperative ERM II, active fiscal policies.

    First-order conditions for the central banks’ problem are as in case 2. Optimal choice of τ by the governments is such that

  • Noncooperative ERM III, active fiscal policies.

    First-order conditions for the central banks’ problem are as in case 1. Conditions for the governments’ problem are as in case 3.

Appendix III

Closed Blocs

When the assumptions b = λ = 0 are made, and the monetary regime inside Europe is asymmetric, the reduced-form equations for employment in the three countries (equations (A18)) are simply given by

where our assumptions about structural parameter values imply x = 0.33 and ϕ = 1,33. Note that, if the exchange rate regime in Europe were symmetric and both European central banks controlled the respective money supplies—as in equations (A18′)—setting λ = 0 would imply that domestic policies have no effects on employment abroad. Endogeneity of the outsiders’ money supply due to the managed exchange rate regime in Europe allows insiders’ policies to have an impact on employment in the outsider countries.

Reduced-form equations for the CPIs when a < 1 are as follows:

where we have maintained the convention that parameters that are not indexed by a number do not depend on a and E1 + E2 = E, as before, M2 = E2 and M2 + M3 = 1.

In the case in which the outs are a small open economy (a = 1), the United States and the ins face each other as two large closed blocs, and CPIs are given by

Our assumptions about structural parameters imply the values for the reduced-form parameters displayed in Table A4.

Table A4.Reduced-Form Parameters When No Transatlantic Spillovers Exist
A = 0.34E = 0.66
a = 0.5
E1 = 0.39E2=0.27M2 = 0.27M3 = 0.73
a = 0.75
E1 = 0.52E2 = 0.14M2 = 0.14M3 = 0.86

The authors thank Matthew Canzonenri, Ton Krueger, Paul Masson, Lodovico Pizzati, André Sapir, and Bart Turtelboom for their comments, Alberto Monti provided valuable assistance.

This is the case studied in this paper, but one could think of different situations, such as, for example, the incentive that the ins may have, it faced with a loss of competitiveness relative to the outs, to weaken the euro relative to the dollar in an attempt to increase their competitiveness vis-à-vis the United States. In the situation we analyze, it is likely that ECOFIN would put pressure on the ECB to loosen the monetary contraction by removing the contractionary bias of non-coordinated policies with the U.S, Federal Reserve Board. See Eichengreen and Ghironi (1997a) on this point.

Using a similar framework, von Hagen and Frarianni (1991) study a different type of asymmetry—the effects of asymmetric demand and supply shocks on otherwise symmetric economies.

A more complete description of the model, together with the solution procedure, is in Ghironi and Giavazzi (1997c).

Although the mode would allow us to analyze policy interactions following different types of shocks, we focus on the case of a symmetric negative supply shock for two reasons. On the one hand, this shock causes inflation and unemployment, and thus forces monetary policymakers to deal with a trade-off between the usual macroeconomic targets: monetary contraction will stabilize inflation at the cost of a deeper recession. On the other hand, after the collapse of the Bretton Woods system, large-scale supply shocks–the oil shocks of 1973, 1979, and the 1991 Gulf War episode—have been among the most relevant disturbances to the world economy. It is not surprising that the debate over the advantages or disadvantages of alternative policymaking regimes has been particularly heated in the wake of such shocks.

See Giavazzi and Pagano (1996) for empirical evidence on episodes of expansionary spending cuts. Eichengreen and Ghironi (1997a) address different issues and discuss also the standard Keynesian case in which increases in government spending have expansionary effects. Eichengreen and Ghironi (1997b) analyze how changes in the extent to which fiscal policy has non-Keynesian effects affect governments’ trade-offs and allow the nature of fiscal policy to be asymmetric across countries.

Our assumptions on the trade pattern are consistent with the implicit assumption that consumers on the two sides of the Atlantic have asymmetric Cobb-Douglas preferences, which lead to constant shares of income being spent on the various goods according to the assumed pattern.

By doing this we assume that inside the currency union there is a single fiscal authority, represented by the ECOFIN Council, This implies two strong assumptions. First, officially, all the members of the EU are currently represented in the ECOFIN Council: assuming that ECOFIN is the fiscal authority of the insiders alone may appear inconsistent with the current institutional framework of the Union. However. officials in Europe have agreed on a two-level structure for the ECOFIN Council, with the representatives of the insiders constituting the first layer of the structure. Given that the Maastricht Treaty does not require EU fiscal policymakers to jointly manage their policies, it is nor unrealistic to treat the two levels of ECOFIN as separate authorities, with the first layer, to which we simply refer as ECOFIN, being the fiscal authority of the ins, separated from the fiscal authority of the outs. Second, the first layer itself will include a number of independent fiscal authorities, one for each member of the currency union: we thus overlook the strategic interactions among them. (These are studied in Ghironi, l993, and Eichengreen and Ghironi, 1997a and 1997b.) Finally, we also assume that the outs can be aggregated into a single entity, with a single central bank and a single fiscal authority. We therefore overlook the consequences of non-cooperation among the authorities of the outs, studied in Buiter, Corsetti, and Pesenti (1995).

It could also be argued that the volatility of taxation may be a source of losses for politically motivated governments, although this effect is not captured in our model.

It is interesting to ask how the policy interactions we analyze would change if the governments were not penalized for actively using their instrument. It turns out that there is an interesting special case, at least when a = 0.5 If governments are free to change taxes without suffering any direct loss from the volatility of their instrument and if their loss function is a “mirror image” of the central banks’ one—that is, it is such that if the central bank attaches weight f to the volatility of inflation and (1 − f) to that of employment, the government does the opposite—the policy choices made by the central bank and the government within each country do not change with changes in the international policymaking regime. In other words, in this special case, the equilibrium of the game between central bank and government inside each country is not sensitive to the nature of the exchange rate regime or to policymaking being cooperative or not. The intuition is that, even if taxation is distortionary, when national policymakers’ preferences are symmetric as described, the map of their indifference curves allows them to achieve a two-targets, two-instruments equilibrium for the game between them. Under this “Tinbergenian” situation, changes in the nature of policymaking at the international level have no impact on the policy choices of each country’s authorities. Although this special case is interesting—since it suggests that there may be circumstances under which the international policymaking regime is irrelevant—we believe that the case we analyze in the paper is more realistic.

Kenen (1995), Spaventa (1996), and Wyplosz (1996), among other, provide a thorough analysis of the arguments in favor of and againsta new EMS regime between the ins and the outs, Persson and Tabellini (1996) argue that a regime that combines inflation targeting with flexible exchange rates is strictly superior to an EMS-type regime. They suggest that this regime would approximate the first-best cooperative outcome of their model quite closely, removing existing incentives to run competitive devaluations, and would outperform an exchange rate—based regime.

Throughout, we refer to the trade-off facing a country’s central bank as the country’s trade off, This trade-off is defined by ∂ql∂n ≡ (∂ql∂k)l(∂nl∂k), whereq is the CPI,n is employment, and k is the instrument controlled by the central bank. Fiscal authorities in all countries rate employment-inflation trade-offs defined by ∂q/∂n a(∂q/∂τ)/(∂n;/∂τ), where τ is the rate of taxation of firms’ revenues. In what follows, we focus on the trade-offs facing the central banks.

We believe this is a realistic assumption. If the central banks attached a larger weight to employment than to inflation, a flatter trade-off would be mote favorable, as it would allow the trading of larger employment gains for smaller inflation losses.

Although social security is currently a source of net revenues for the U.S. government, slow population growth may also make the problem relevant for the United States in the future. He sides, a balanced budget amendment, if it were introduced, would do away with fiscal flexibility.

For example. Eichengreen and Ghironi (1997a) show that, under reasonable circumstances, the ECB may not be interested in cooperating with the Federal Reserve.

This discussion of the role of ECOFIN is implicitly consistent with all members of the EU being represented in that institution. Recall footnote 7.

Because sevral reduced-form parameters have ambiguous signs, in order to draw clear-cut conclusions, we perform a numerical simulation of the policy game, based on assigning “consensus” values to the structural parameters of the model. Our assumptions about the latter, as well as the implied numerical values of reduced forms and trade-offs, are described in Appendix I. As we shall see below, results of the simulations turn out to be consistent with the general results about the trade-offs described in the previous section, which lends some robustness to our conclusions. Note that in Table 1 and in the following ones, the values of the policy instruments and of the endogenous variables should be multiplied by x (the supply shock), while the values of the loss functions should be multiplied by x.2 A positive value of x, is a negative supply side shock, which lowers employment and raises the CPI. Given that all variables in our model are in logs, the numbers we report in the tables are the elasticities of policy instruments ant endogenous variables with respect to the supply shock implied by the relevant policymaking regime and EMU size. We then calculate the losses implied by those elasticities.

In Table 1 this can be seen comparing the outcome for a ¼I with the case a = 1, and remembering that with a = 1 the impact of the outs on the ins and on the United States is negligible (mlǀ al = 0.5.< mlǀa = 0.75 <mlǀa =1 <0), ml denotes money in the monetary union.

The effective real exchange rate of the insiders is: z1bz1 + (I−a)(1−b)z3 where z1 andz3are the dollar-euro and outs-euro real exchange rates, respectively.

When a = (1.75, producers’ prices (p) are equal to 0.468Ix; when instead a = 0.5. they are equal to 0,4618x.

The effective real exchange rate of the United States is defined as: zUS>≡abz1 + (1−a)bz2, where z2 is the dollar-outs real exchange rate.

Remember that the outs’ trade-off improves with respect to both the ins’ and the U.S. trade-off as a increases from 0.5 to 0.75.

*#x2019;This observation shows that facing a more favorable trade-off is not necessary to successfully run beggar-thy-neighbor policies: the federal Reserve faces the same trade-off as the ECB, but still manages to appreciate the dollar in real terms against the euro, thus exporting some inflation to the currency union. The absence of intra-EU cooperation and the presence of nonnegligible outsiders that successfully export inflation to both the ins and the United States shifts the balance between the Federal Reserve and the ECB in a direction that is favorable to the U.S. authorities, Ghironi (1993) and Eichengreen and Chironi (1997a) show that the dollar-euro exchange rate would also move in a situation in which there are no outsiders—so that the currency union has the same size as the United States—but fiscal authorities inside the currency union do not cooperate.

When it plays cooperatively, the central bank of nonnegligible outs is driven to the same situation as that of the ECB and the Federal Reserve with a = 1 and no cooperation, and is even worse off than the central bank of negligible outs when there is no cooperation. The result that international monetary cooperation may be counterproductive from the perspective of some or all of the players is not new in the literature on international interactions. In Rogoff (1985), cooperation can be counterproductive when it exacerbates time inconsistency problems in the conduct of monetary policy. In Eichengreen and Ghironi (1997a), ECB-Federal Reserve cooperation can be counterproductive from the central banks’ perspective owing to the induced adjustments in fiscal policies. Here, cooperation is counterproductive from a player’s perspective essentially because it prevents the player from “riding a favorable trade-off as much as it would without cooperation.

The reader can interpret the results for the case of more active fiscal policies on the basis of the intuitions provided below.

Remember that a tax cut raises firms’ labor demand, while at the same rime reducing government spending because of our assumption that the government budget is always balanced. Thus the net effect on output is ambiguous. However, if the interest rate semielasticity of money demand is sufficiently small, a tax cut unambiguously raises output and employment.

Governments’ trade-offs were defined in footnote 10.

Remember that the governments’ loss function depends also on the volatility of taxation when governments play actively.

Ghironi and Giavazzi (1997c) provide a more detailed discussion of this case.

Although Such an extreme value for b is obviously unrealistic, trade flows across The Atlantic are of much less relevance than those occurring inside Europe, and the extreme case we want to study may still be of interest, as we shall see below.

A zero value for the interest rare semielasticity of money demand—λ—is the standard assumption of many models of international policy interactions. (See Canzoneri and Henderson, 1991. for an example.) It implies, however, that economic policies have no effect on output and employment abroad if exchange rates are flexible, and it prevents a negative supply side shock from causing unemployment. Moreover, setting λ =0 not only insulates the European and U S. blocs, when the assumption is combined with b = 0, but also removes a channel of transmission of intra-European policy spillovers. Thus, the situation that we are going to consider for the two European regions differs from that of a two-country model in which both channels of transmission matter. Nonetheless, the results that follow about the two European regions—which correspond to those that would be obtained in a simple two-country model in which externalities only originated from trade in goods—allow us to make explicit comparisons between the situation in which there are transatlantic policy spillovers and that in which the two Western blocs are completely closed with respect to each other.

The reduced forms for this case are presented in Appendix III. See Table 1 for the corresponding results in the presence of transatlantic spillovers.

The effective real exchange rate of the insiders is now given by zl= (1− a)z3. When a = 1, this is obviously zero. When a increases from 0.5 to 0.75, the effective depreciation of the euro with respect to the outs’ currency diminishes from—0.0415x to − 0.0268x.

Under the assumptions of this exercise, the reduced form for the insiders’ PPI—see Appendix II—reduces top = αnl + t+x = αm + (1 −α)τl + x. Since an analogous expression holds for the United States, one immediately finds the expressions for the reduced form parameters A (= α) and E (= 1 − α). When a increases from 0.5 to 0.75 and 1, pl increases from 0.4689x to 0.4764 xand 0.4901x.

Ghimni and Giavazzi (1997b) show that indeed the result also holds in a two-country mode! in which both channels of transmission are at work.

The intuition for why the central bank of the outsiders is more aggressive when b= λ = 0 than in Table 1 is explained in (Ghironi and Giavazzi (1997c).

Although different from that and also from the outcome achievable under a scheme of global monetary cooperation. The intuition for the difference between “closure” as we have modeled it and transatlantic monetary cooperation runs as follows. Each country’s policy affects the other countries’ endogenous variables through two channels of international transmission when transatlantic spillovers are allowed: trade in goods and trade in assets. Transatlantic monetary cooperation without intra-European cooperation would internalize transatlantic externalities, leaving both intra-European externalities at work. Setting b =λ = 0 removes both channels of international transmission across the Atlantic, but also eliminates the intra-European externality going through the financial markets, thus removing one of the sources of inefficiency in non cooperative intra-EU policymaking as well. Besides, there would be the problem of how to solve for the equilibrium with transatlantic cooperation but without intra-EU cooperation in our model. Conceptually, we would have two coalitions of players that play Nash against each other. But there would be one plaver—the Federal Reserve—which is a member of both coalitions. Thus, in a sense, there would be a player that is playing Nash against itself, and this causes the nonexistence of an equilibrium. It can also be shown that “closure” is different from global monetary cooperation. The difference is again given by the role of intra-European externalities: removing transatlantic externalities eliminates the source of the contractionary bias in transatlantic monetary interactions—which is already welfare improving for all players in most cases—but does not remove completely the inefficiency of non-cooperative policymaking between the two European monetary authorities, as it is done by global monetary cooperation. Note that, from the outs’ central bank’s perspective, this inefficiency is a source of gains, because it allows the achievement of a lower inflation through aggressive exchange rate policies. (Ghironi and Giavazzi. 1997c. provide more details on this point.)

Basevi, Delbono, and Denicolé (1990) analyze a formal model of monetary and trade interactions. For some contributions to the debate on ttade and currency areas, see Federal Reserve Bank of Karsas City (1991).

See Eichengreen and Ghironi (1997a) for a discussion of disagreements between central banks and governments on the desirability of transatlantic monetary cooperation.

As the results of Table 6 are sufficient to make the point that “the presence of the United States does make a difference” in our model, we do not discuss here the results of the simulated game when intra-EU monetary cooperation and fiscal activism are considered. It is possible to show that, when monetary cooperation is coupled with (limited) fiscal activism, all players agree-on the desirability of a small currency union under the assumptions of this section. The results of the simulations are available from the authors upon request.

The debate mainly focuses on an EMS-style arrangement versus a flexible exchange race regime coupled with inflation targeting. Here, in order to focus on the role of the exchange rate regime in affecting the results, rather than assuming rigid inflation targeting rules, we maintain the assumption that central banks choose their instruments to minimize loss functions in which a much larger weight is attached to inflation than to unemployment The implications of rigid inflation targeting are discussed by Persson and Tabellini (1996), Frankel (1989) analyzes alternative rules for the conduct of monetary policy.

This argument is consistent with the pattern of the dollar-euro real exchange rate that we observe in our simulations: the dollar appreciates in real terms against the cum under the ERM II regime, hut it depreciates under the symmetric regime, when the ECB implements a much more aggressive monetary policy vis-à-vis the Federal Reserve. Besides, the results of this exercise seem to suggest that the potential gains from “approximating transatlantic cooperation via isolation of the two Western blocs” could be trigger when both European central banks control the respective money supplies, as this induces more contractionary transatlantic interactions than those in Table 1.

The intuition for this result lies in the different characteristics of the alternative exchange rate regimes in Europe. As the reader can check by comparing the reduced-form equations under the two regimes, when the managed exchange rate regime is implemented in Europe, owing to the endogeneity constraint on m, the reduction in the ins’ monetary contraction going from a = 0.75 to a = 1 has a harmful impact on the outs’ CPI. As a consequence, the outs’ central bank optimally reacts by strengthening its contractionary stance. When the endogeneity constraint on mo is removed and the intra-European monetary arrangement is symmetric, going from a = 0.75 toa = 1, the less contractionary policy by the ECB is beneficial in terms of stabilizingqo—and m1 has a larger impact on it. Consequently, the central bank of the outsiders reacts optimally by loosening its stance.

Letting ≻ denote “preferred to” and omitting the as. under the ERM II regime, the ranking of the outs’ government preferences was 0.5 ≻ 0.75 ≻ 1; under “closure” of the two Western blocs, it was 0.5 ≻ 1 ≻ 0.75; and under the symmetric regime we have 1 ≻ 0.5 ≻ 0.75.

We remark that the key in driving the result is the change in the position of the ins’ employment-inflation trade-off with respect to the U.S. one, the outs’ trade-off being unchanged across intra-EU regimes.

A thorough discussion of the results obtained when fiscal authorities are active players in the game would require references to the trade-offs facing the governments under the symmetric intra-EU.’ regime. We refrain from exploring the issue here for reasons of brevity.

Alternative transatlantic arrangements are studied in Ghironi (1993) and Eichengreen and Ghironi (1997a and 1997b). In both those analyses, EMU is assumed to encompass the whole EU, so that there are no outs. Those models, however, allow for the absence of fiscal cooperation within the currency union.

Similarly, the model provides some intuition about what could happen if a multiplicity of outsiders’ central banks were considered. For example, one could argue that, in the framework of our model, even if the outs’ central bank always prefers the union to be large, the small union outcome may obtain also as a “perverse” result of each of the individual outs’ central banks’ incentive to be the lucky small outsider reaping the benefits of a relatively more favorable trade-off. The same incentive may have destabilizing implications for cooperative arrangements among outs’ central banks.

Recall that we have also implicitly assumed that all ins’ governments cooperate within the ECOFIN Council, but this need not be the case.

At least in the first few years after the beginning of Stage III. it is likely that also the European Council will indeed attach a great value to monetary stability and to the establishment of the anti-inflationary reputation of the ECB. Nonetheless, it is not unrealistic to think about conflictive situations of the type that we are analyzing being resolved in favor of the ECOFIN Council. Our model is not suited to analyze whether this could have negative consequences on the ECB’s replication. If the ECB were forced to accept the Council’s decisions, it is unclear whether its reputation would suffer or not. For example, the Bundesbank’s reputation did not suffer when the German central bank was forced to accept one-to-one conversion of ostmark into deutsche mark by the German government, but it will take time before the ECB’s reputation is as strong as the Bundesbank’s. Note that the model suggests that, if the conflict over intermediate values of a is resolved in favor of ECOFIN’s preferences, both ins’ authorities may want the transition to a currency union encompassing the whole EU except a small open economy to be relatively fast, because a = 1 is preferred to a = 0.75 by both players.

See Eichengreen and Ghironi (1995) for a discussion of these arguments.

Indeed, the proper functioning of an EMS-style arrangement could well be undermined by the ECB’s negative attitude toward such a regime.

All variables represent deviations of actual values from zero-shock equilibrium values. All variables except interest rates, public expenditures, and tax rates are expressed in logarithms, and time subscripts are dropped whenever possible.

Using uppercase letters to denote anti-logs, domestic firms maximize Profit = (1 − τ) PYWN, subject to Y = Nl −α/X. Each firm is a price taker in the output and in the labour Market and is taxed on its total revenues. The first-order condition for maximization with respect to Nis (1 − τ)P(1 − α)N/X = W. Taking logs, approximating ln(l − τ) with −τ, and omitting unimportant constants, we obtain equation (A2). (See Alesina and Tabellini. 1987.)

The ins’ propensity to import From the outs is (1 − a) times one minus the ins’ propensity to import from the United States. Thus, if ins’ propensity to import from the United States is b, the ins’ propensity to import from the outs is (1 − a)(1−b), and the total propensity to import of the ins b+(1 − a)(1 −b).

It is r = arl + (1 − a)ro because agents can freely borrow in all countries. However, it can be easily shown that identical consumption patterns in the ins and outs economies coupled with perfect capital mobility imply rl = ro = r.

The increase in demand due to a real depreciation of the domestic currents depends on two factors: the common elasticity parameter δ and the size of the country with respect to whose currency the domestic currency is depreciating. Thus, for example, in the case a = 0.5, if the euro depreciates against the dollar, the increase in demand For ins’ goods is twice as much as it would be were the euro depreciating against the outs’ currency, reflecting the fact that the U.S. economy is twice the outs’ one and that, with perfect mobility of goods, “depreciation against a larger market is more profitable.” The larger a is, the smaller the impact of a real depreciation against the outs, for a given impact of an analogous depreciation against the dollar. If the outs are a small economy, their impact on the demand For the ins’ goods is correspondingly small. This intuition is consistent with our assumptions about the pattern of trade: as a approaches 1, the ours spend a larger share of their income on the ins’ goods, but their size is small. Also, the ins spend a smaller share of their income on the outs’ goods. Thus, a real depreciation of the euro against the outs’currency has a smaller impact on the demand for the ins’ goods as a increases. An alternative explanation for a higher elasticity of demand For European goods to the transatlantic real exchange rates than to the intra-European exchange rate could be based on the characteristics of the goods that are traded and on the presence of impediments to perfect mobility of goods across the Atlantic. In this sense, if the euro depreciates against the dollar, this may have a larger impact on demand for the ins’ goods than a depreciation against the outs’ currency, because, goods being imperfect substitutes, the characteristics of international trade may make it easier and more convenient for ins consumers to shift from U.S. goods to insiders’ than from outsiders’ goods to insiders’.

See Ghironi and Giavazzi (1997a and 1997c) for a more detailed discussion of the wage-setting process.

Ghironi and Giavazzi (1997c) for the solution of the model.

The expression is further simplified when a = 0.5, in which ease the two European countries are symmetric in each respect. In this ease we have Θ1 = Θ2 = Θ/2, Ψ1 = Ψ2 = Ψ/2. United States variables depend on United States policy instruments and on the arithmetic average of the European ones—and also: Λ1 = Λ3, Λ2; = Λ4, Ω1 = Ω3, Ω2 = Ω4.

This is because the two European countries have identical consumption bundles (see the pattern of trade), and therefore Purchasing Power Parity (PPP) holds in terms of CPIs. The same is not true for the United States versus European economies, because the consumption baskets are asymmetric across the Atlantic. This is due to our implicit assumption that consumers on the two sides of the Atlantic have asymmetric Cobb-Douglas preferences (recall footnote 6) As a consequence, real interest rates are not equalized in Europe and the United States, the differential depending on movements in the real exchange rates.

Again, matters are simpler when a=0.5, in which case we have: B1 = B2 = B/2, Γ1 = Γ2. = Γ/2, A1 = A3,A2 = A4, E1 = E2,E3 = E4.

Recall that it is qlqo = −e3 When a = 1, changes in e3 have no impact abroad, and the same is true of changes in the outsiders’ fiscal policy. Hence, e3 has a one-to-one impact on qo. and the latter is not affected by changes in τo

Moreover, the parameters whose value does not depend on a are identical across intra-European exchange rate regimes, as our choice of notation indicates. The intuition for this result is apparent if one observes the reduced-form equations for the case a =1. The parameters wc are referring to are indeed those that would characterize the interaction between the United States and a European currency union whose size were identical to that of the United States, These two entities are unaffected by the outsiders’ policy choices, the outs being a negligible entity. For the same reason, the intra- European exchange rate regime does not affect the values of the parameters in the reduced-form equations for the ins’ and U.S. variables when a = 1.

Recall footnote 24.

See footnote 29 and Appendix III.

References

    Alesina,Alberto, andVittorioGrilli,1994, “On the Feasibilicy of a One-Speed of Muttispeed European Monetary Union,”Chapter 6 inThe Political Economy of European Monetary Unification,ed. byBarryEichengreen andJeffryFrieden (Boulder, Colorado: Westview Press), pp. 10727.

    Alesina,Alberto, andGuidoTabellini,1987, “Rules and Discretion with Noncoordinated Monetary and Fiscal Policies,”Economic Inquiry, Vol. 25 (October),pp. 61930.

    Basevi,Giorgio,FlavioDelbono, andVincenzoDenicolϕ,1990, “International Monetary Cooperation Under Tariff Threats,”Journal of International Economics,Vol. 28 (February), pp. 123.

    Buiter,WillemH.,GiancarloCorsetti, andPaoloA. Pesenti,1995, “A Centre-Periphery Model of Monetary Coordination and Exchange Rate Crises,”CEPR Discussion Paper No. 1201 (London: Centre for Economic Policy Research,July).

    Canzoneri,MatthewB., andDaleW. Henderson,1991, Monetary Policy in Interdependent Economies: A Game-Theoretic Approach (Cambridge,Massachusetts: MIT Press).

    Council of European Communities,1992, Treaty on European Union (Luxembourg: Office for Official Publications of the European Communities).

    De Grauwe,Paul,1996, “The Pros and Cons of a Mini Currency Union”(unpublished; Leuven: University of Leuven).

    EichengreenBarry, andFabioGhironi,1995, “European Monetary Unification: The Challenges Ahead,”CEPR Discussion Paper No. 1217 (London: Centre for Economic Policy Research, July).

    BarryEichengreen, andFabioGhironi,1997a, “How Will Transatlantic Policy Interactions Change with the Advent of EMU?” (unpublished; Berkeley, California: University of California).

    BarryEichengreen, andFabioGhironi,1997b, “Fiscal Asymmetries and U.S.-Europe Interactions in the EMU Era”(unpublished;Berkeley, California: University of California).

    Federal Reserve Bank of Kansas City,1991, Policy Implications of Trade and Currency Zones, proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming,August22–24.

    Frankel,Jeffrey A.,1989,“International Nominal Targeting (INT): A Proposal for Overcoming Obstacles to Policy Coordination,”in Global Disequilibrium in the World Economy, ed. byMarioBaldassari,JohnMcCallum, andRobertMundell(New York: St. Martin’s Press), pp. 257–94.

    Ghironi,Fabio,1993, “Regimi di tasso di cambio e coordinamento internazionale delle politiche economiche: Che cosa abbiamo imparato in dieci anni di letteratura?”Tesi di Laurea (unpublished;Milan: Bocconi University).

    Ghironi,Fabio, andFrancescoGiavazzi,1997a, “Currency Unions, International Monetary Regimes and the Employment-Inflation Trade-Off”(unpublished; Berkeley, California: University of California; Milan: Bocconi University).

    Ghironi,Fabio, andFrancescoGiavazzi,1997b, “Is Small Beautiful? Currency Unions and the Employment-Inflation Trade-Off”(unpublished;Berkeley, California: University of California; Milan: Boceoni University).

    Ghironi,Fabio, andFrancescoGiavazzi,1997c, “Out in the Sunshine? Outsiders, Insiders, and the United States in 1998,”CEPR Discussion Paper No. 1547 (London: Centre for Economic Policy Research, January).

    GiavazziFrancesco, andAlbertoGiovannini,1989, “Monetary Policy Interactions Under Managed Exchange Rates,”Economics,Vol. 56 (May),pp. 199213.

    FrancescoGiavazzi, andAlbertoGiovannini, andMarcoPagano,1996, “Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience,”Swedish Economic Policy Review, Vol. 3 (Spring), pp. 67103.

    Kenen,PeterB.,1995,Economic and Monetary Union in Europe: Moving Beyond Maastricht (Cambridge: Cambridge University Press).

    Persson,’Torsten, andGuidoTabellini,1996, “Monetary Cohabitation in Europe,”CEPR Discussion Paper No. 1380 (London: Centre for Economic Policy Research,May).

    Rogoff,Kenneth,1985, “Can International Monetary Cooperation Be Counterproductive?”Journal of International Economics,Vol. 18 (May), pp. 199217.

    Spaventa,Luigi,1996, “Out in the Cold? Outsiders and Insiders in 1999: Feasible and Unfeasible Options,”CEPR Discussion Paper No. 1379 (London: Centre for Economic Policy Research, April).

    von Hagen,Jürgen, andMicheleFratianni,1991, “Policy Coordination in the EMS with Stochastic Asymmetries,”in Financial Regulation and Monetary Arrangements After 1992, ed. byClasWihlborg,MicheleFratianni, andThomasD. Willett(Amsterdam: Elsevier Science Publishers), pp. 25575.

    Wyplosz,Charles,1996, “An EMS for Both “Ins” and “Outs”: The Contractual and Conditional Approach,”Swiss Political Science Review, Vol. 2 (Spring), pp. 17883.

    Other Resources Citing This Publication