This Selected Issues paper analyzes budgetary developments in Ireland during the 1990s. The paper highlights that Irish fiscal policy has been central to the social consensus on macroeconomic policies. The economic buoyancy has reinforced this cycle by facilitating the tax cuts and increases in social spending that have been instrumental to the social consensus on policies, while also helping to keep deficits low. The paper also discusses the participation of Ireland in the European Monetary Union.


This Selected Issues paper analyzes budgetary developments in Ireland during the 1990s. The paper highlights that Irish fiscal policy has been central to the social consensus on macroeconomic policies. The economic buoyancy has reinforced this cycle by facilitating the tax cuts and increases in social spending that have been instrumental to the social consensus on policies, while also helping to keep deficits low. The paper also discusses the participation of Ireland in the European Monetary Union.


A. Introduction

24. Ireland appears well positioned to qualify for early participation in European Monetary Union (EMU) and the market seems to assign a high probability to this event.9 This chapter examines economic implications for Ireland of joining the EMU, focusing in particular on the challenges that would arise if the United Kingdom does not participate.

25. Exchange rate developments, including effects of market speculation about the entry rate into EMU, are the focus of section B. Section C summarizes the main results of a government commissioned study of the economic implications of EMU. Section D highlights the position of the Irish economy relative to other EU members and present some empirical results on correlations of industrial production Finally, a discussion on policy challenges once in EMU and concluding remarks are offered in section E.

B. Exchange Rate Developments

26. The participation of the Irish pound in the Exchange Rate Mechanism (ERM) at its inception in 1979 marked the end of a long standing formal link with sterling. The early experience in the ERM was characterized by instability, with the Irish pound’s central rate being realigned 10 times during 1980-87, culminating with a sharp drop in 1986 when the currency was devalued twice by 3 and 8 percent. The Irish currency was then quite stable in the ERM narrow band during the period of macroeconomic and fiscal stabilization from 1987 until the currency turmoil of 1992 (sterling joined the ERM in 1990). Under pressure following sterling’s September 1992 departure from the ERM and subsequent sharp depreciation, the Irish pound was devalued by 10 percent in early 199310 (Chart 1).



(Indices: 1979=100) 1/

Citation: IMF Staff Country Reports 1997, 077; 10.5089/9781451818697.002.A002

Source: IMF, International Financial Statistics.1/ The base year, 1979, is the year the Irish pound delinked from parity with the sterling and joined the ERM.

27. Since the introduction of the wide ERM bands in August 1993, Irish monetary policy has focused on price stability and the ultimate objective of early EMU entry. Given the high degree of openness of the Irish economy, the implementation of this policy has focused increasingly on the nominal effective exchange rate. In contrast with the 1987-92 period, the Irish pound has fluctuated considerably against ERM currencies, from a low of 8 percent below its central rate against the deutsche mark in early 1995 to a peak of 11 percent above in early 1997. These movements traded to coincide with swings in the value of sterling against the deutsche mark; nevertheless, the Irish pound has also fluctuated significantly against sterling (Chart 2).



Citation: IMF Staff Country Reports 1997, 077; 10.5089/9781451818697.002.A002

Source: IMF, Information Notice System.1/ Data are expressed in foreign currency units per Irish pound.

28. To illustrate the responsiveness of monthly changes in the Irish pound to changes in sterling and the deutsche mark, a statistical model was estimated (see Appendix I for the empirical specification). The sample is divided in three periods: The first is the early EMS period (1979-87), the second is the period of macroeconomic stabilization associated with fiscal consolidation (1987-92), and the third period covers the experience with wide ERM bands (1993-97). The estimated β-parameters (Table 1) are composite measures reflecting a range of factors including economic fundamentals and economic policies. The result that stands out is the shift in parameters toward increased weight to sterling relative to DM in the period following the widening of the ERM bands.

Table 1.

Responsiveness of Changes in Irish Pound to Changes in Sterling and DM, 1979-93

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Sources: IFS; and staff calculations.

29. The Irish pound’s recent position in the upper end of the ERM band has been associated with a significant interest rate differential with Germany at the short end (reflecting differences in cyclical positions) and substantial convergence at the long end. Solid expectations about an early participation in the EMU, associated with lower Irish interest rates, are underlined by favorable performance on the Maastricht criteria and by repeated commitments from Irish officials to early participation.

30. In late April, speculation about the eventual entry rate of the Irish pound into EMU brought the currency down sharply in the ERM band (Chart 2). On May 2 the central bank raised official interest rates by SO basis points to 6.75 percent.11 The pound subsequently recovered somewhat but toward end-May it slipped again in the band on renewed speculation, and was trading at about 7 percent above its central rate in early June. This speculative episode appears to have been fed by uncertainty about the locking procedures for countries participating in stage 3 of EMU. With sterling strengthening further against ERM currencies in response to heightened uncertainty about prospects for EMU, the Irish pound briefly fell further against sterling to about £0.90 before recovering to £0.92 as of June 11. In effective terms, most of the 5 percent appreciation of the Irish pound during 1996 was unwound in the first half of 1997.

C. Evaluating Costs and Benefits of EMU

31. A government-commissioned study on EMU was undertaken in 1996 by the Economic and Social Research Institute (ESRI, 1996). The objective of the study was to assess the likely economic implications of EMU for Ireland with “particular reference to employment, including at sectoral level, in the context of various membership scenarios for relevant member states.” The report distinguishes between five channels through which EMU participation will exert influence on Ireland: interest rates; transactions costs; competitiveness; foreign investment; and uncertainty affecting trade, investment and output. As the last two channels were not viewed as readily quantifiable, the ESRTs analysis focused mainly on the first three.

32. The ESRTs analysis is cast in terms of weighing the costs of possible competitiveness loss against benefits from increased policy credibility associated with lower interest rates. The potential gains from higher policy credibility may be significant. The report notes that since Ireland joined the ERM, the average excess returns on Irish pound assets compared with DM assets stood at about 2.6 percent per annum in the period 1979-93 (higher excess returns than any other ERM country). This is attributed as mainly reflecting a cost associated with lack of monetary policy credibility in the narrow ERM band as the market has continually priced in a higher margin in Irish interest rates than has been justified ex post by the depreciation of the Irish currency. However, between 1993 and 1995, the currency risk premium reduced sharply and the mean excess return declined to 0.6 percent per annum.

33. The calculation of benefits to the Irish economy from higher policy credibility associated with lower interest rates is based on three assumptions. First, it is assumed that EMU interest rates will equal pre-EMU DM interest rates. Second, Irish government interest rates are assumed to equal those in the EMU as a whole. Third, the fiscal benefits of lower interest rates are assumed to fully benefit consumers by cuts in direct taxation, reducing wage increases and labor costs resulting in improvements in competitiveness.

Empirical implementation

34. The report uses three models to gauge the central effects of an EMU membership. It uses two existing macroeconomic models in capturing the behavior of the major EU economies and to quantify the effects of changes in interest rates and competitiveness on the Irish economy, respectively. A new quarterly model is used to evaluate the question of speed of adjustment of prices and wages in the wake of economic shocks (exchange rate changes).

35. The central estimates in the report compare the economic consequences for Ireland if the United Kingdom remains outside EMU with the case where both the United Kingdom and Ireland do not join while Germany, France and at least four other countries form the EMU. Three different scenarios (see below) are used to assess the economic impact of EMU. The first scenario (tranquil) quantifies the steady-state effects and abstract from any major shocks; the second scenario (turbulent) quantifies the cost of slow adjustment of the economy to an exchange rate shock; and the third scenario (blustery conditions) integrates the results from the other scenarios.

36. It should be noted that since the ESRI report was published (summer 1996), Irish long-term rates have already moved lower, reflecting convergence trades in anticipation of EMU membership. Meanwhile, as noted earlier, the Irish pound has depreciated sharply against sterling, providing a cushion against future sterling depreciation and its possible implications for Irish competitiveness.

Main results

Tranquil scenario

37. The projections under the tranquil conditions assume that EMU inflation will be maintained at or around 2 percent. The U.S. dollar is assumed to appreciate against the euro in the long term, and the United Kingdom policy is assumed to follow a consistent path with a stable inflation rate approximately 0.5 percentage point higher than the EMU average, resulting in a 0.5 percent depreciation of sterling per annum.

38. The elimination of foreign exchange transactions costs is estimated to raise GNP by a modest 0.1 percent in the short to medium term reflecting reduced cost for traders and travelers, but also loss of employment in the financial sector.

39. The bulk of benefits in the simulations stems from a decline in interest rates resulting from lower inflation and, more important, removal of devaluation risk in EMU. Wholesale interest rates are predicted to decline by 1 percent in the medium term. Over the first five years of membership, this decline is estimated to bring an additional 1.7 percent to GNP (Table 2).

Table 2.

Medium-Term Effects of Irish Membership of EMU

(Average change in levels compared to benchmark)

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Source: ESRI (1996).

40. The effect of exchange rate movements on competitiveness would crucially depend on the behavior of starling if the United Kingdom remained outside EMU. With the modest trend depredation of sterling envisaged in the tranquil scenario, Ireland would not face a large trend loss in competitiveness. The cost of Ireland joining EMU without the United Kingdom is contained at 0.4 percent of GNP as the economy adjusts to the new regime.

41. Bringing these elements together, the model computation suggests an average gain to GNP from Ireland membership of EMU of 1.4 percent, with employment estimated to average about 24,000 higher than if Ireland remains outside.

Turbulent scenario

42. In this scenario, a simulated sharp decline in sterling is used to quantify the costs of a major nominal shock. Following a 20 percent depreciation of sterling against the euro (with Ireland an EMU participant), the maximum reduction in Ireland’s GNP of 1.6 percent would be felt in the second year associated with a reduction of28,000 jobs. If Ireland were to retain its own currency, the losses from a simulated sterling shock would be 0.9 percent and 16,000, respectively.

Blustery conditions

43. Using a composite measure of frequency and intensity of actual shocks, probabilities were assigned to the risk of various shocks in EMU. Weighing the costs against the benefits, an overall assessment points to a cost of 1 percent of GNP, leaving the net effects on income and employment at 0.4 percent of GNP and 10,000, respectively.

44. A number of unquantifiable effects are also identified which tend to bolster the benefits from EMU membership. These include beneficial effects on investor confidence, and investment plans among Irish and overseas investors as well as wider political factors. Overall, the results indicate that the economic benefits are modest in terms of output, employment and trade from EMU membership but including unquantified effects from membership the benefits are likely to be more significant.

Sectoral studies


45. There is scope for large variations in the impact of EMU membership across industrial sectors depending on how they will gain from lower interest rates and the degree to which they are exposed to currency risk.

46. A permanent reduction of interest rates of 1 percent will primarily benefit the building industry. In the initial years of EMU, up to 8,000 jobs are estimated to be created in that sector. Other beneficiaries include heavily indebted companies either because of their capital structure or because they have a big requirement for working capital. These are generally small-to medium-sized firms with a large domestic market.

47. The sectors most exposed to currency risk include clothing, food processing and textiles with a large market in the United Kingdom and/or exposed to United Kingdom competition in their domestic market. The fast growing export-oriented sectors enjoy high margins and appear relatively insensitive to Irish interest rates and currency fluctuations.

The financial services sector

48. In the short run, banks will incur once-off costs of introducing the euro. In the longer term, however, a substantial fall in foreign exchange business will result in reduced employment and profits. Also, lower interest rates will tend to shrink the spread over deposit rates at least for large firms. However, growth in other businesses is expected to compensate for the fall in interest margins.

49. The introduction of the euro could, in the absence of appropriate counter measures, result in greater international concentration of wholesale financial market intermediation, particularly affecting the Dublin-based market structure, facilitating Irish bond and money market transactions. The structure of the domestic equity market, however, is less likely to be affected.

The retail distribution sector

50. The long-term effects on the sector are expected to be limited. In the short run, however, the impact of the transition to a new currency will be significant because of large volumes of cash handled by the sector. The introduction of a new currency will require expenditure on both staff training and on computer systems.

The agriculture and tourism sector

51. Set against a background of pressures of international trade rounds and likely changes to the Common Agriculture Policy, the specific EMU effects on agriculture are relatively minor. With a high level of indebtedness, the sector will benefit from lower interest rates. Competitive effects will feed into agriculture prices more pronounced than in the past. This is an issue in the case of a sterling depreciation, lowering incomes in the sector.

52. The tourism sector is likely to be a net beneficiary, with saving resulting from reduction in transactions cost and lower interest rates outweighing costs from competitiveness.

D. Correlations of Economic Shocks

53. Ireland’s strong macroeconomic performance in recent years is highlighted by comparing economic growth and price inflation with the rest of Europe (Chart 3). One aspect of joining a common currency, recognized by the Optimum Currency Area (OCA) theory, is that costs associated with pegging the currency largely depend on the extent of trade ties and the extent of correlation of economic shocks. In terms of similarity of trade structure and degree of intra-industry trade, Ireland ranks 10 and 11, respectively out of 14 European countries. Ireland’s first place ranking in terms of intra-EU trade with other EU countries is mainly a result of trade with the United Kingdom (ESRI, 1996).



Citation: IMF Staff Country Reports 1997, 077; 10.5089/9781451818697.002.A002

Sources: IMF, International Financial Statistics; Department of Finance; and OECD, Main Economic Indicators.1/ Real GNP for Ireland, real GDP for E.U. and O.E.C.D.

54. The point has been made that the OCA criteria themselves can change over time altering the relationship between countries income correlations and the intensity of their trade links.12 One hypothesis in the Irish case would be that the strong growth and diversification of external trade (Chart 4) over the last 25 years have contributed to moderate the susceptibility of the economy to asymmetric shocks and moved the economic cycle to a position more in line with the rest of the European Union (EU). In particular, the share of the United Kingdom in Ireland’s external trade has declined significantly since EU accession in 1973 (Table 3). A parallel development, also contributing in this regard, is the influx of foreign direct investment (EDI) with high levels of output per employee and export orientation: in 1996, the sales-to-GDP and sales-to-export ratios of FDI were 30 percent and 37 percent, respectively (Leddin and Walsh, 1997).



(Trade statistics basis)

Citation: IMF Staff Country Reports 1997, 077; 10.5089/9781451818697.002.A002

Sources: Central Statistics Office; and IMF, Direction of Trade.1/ The fall in EU trade in 1993 coincides with the discontinuity that arises from the adoption of the Eurostat system. This system better distinguishes between exports to the EU and those re-exported through EU ports (Rotterdam effect).
Table 3.

Share of Irish Trade with Main Trading Partners, 1972-95

(In percent)

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Source: The Central Bank (1997).

55. As a result of profound changes in the Irish economy, the assessment of the Irish experience on the basis of business cycle correlations may importantly depend on the period under study.13 Table 4 shows correlations of industrial production14 both between Ireland and other EU countries, and between Germany and other EU countries for two different samples (1960-79 and 1980-96). It should be noted that industrial production reflects only a part of economic activity and comparisons of Ireland with other countries are complicated by the differences between its modern and traditional industrial sectors.

Table 4.

Correlation of Cyclical Component of Industrial Production 1/

article image
Sources: IFS; and staff calculations.

The early sample for Denmark is 1968(1)-1979(4), the late sample for Austria is 1980(1)-1995(4) and for Italy 1980(1)-1993(4).

56. To handle the possibility of spurious correlation resulting from data being non-stationary, data are de-trended using the Hodrick-Prescott (HP) filter. Correlations between the cyclical components of the variables fail to distinguish between the impact of a shock and the subsequent adjustment process. Therefore, correlations of the shocks to industrial production, identified with the residuals in an OLS regression of the cyclical component on four own lags, are also presented (Table 5, see Appendix I for a detailed explanation).

Table 5.

Correlation of Shocks to Industrial Production 1/

article image
Sources: IFS; and staff calculations.

The early sample for Denmark is 1968(1)-1979(4), the late sample for Austria is 1980(l)-1995(4) and for Italy 1980(1)-l993(4).

57. A high correlation coefficient for a pair of countries signifies a common cause of cyclical shocks. A low coefficient points to diverse sources of shocks and indicates that the required relative price adjustments within the currency union are likely to be high.

58. Notwithstanding trade growth and diversification, the results do not appear to lend support to the hypothesis that Ireland’s business cycle was on average more closely aligned with the continental economies during 1980-96 than 1960-79. It is evident that the correlations are much lower when the analysis center on the shocks to industrial production than on its cyclical component. It is interesting to note that correlations with Germany are generally weaker in the later sample than in the early one (the unweighted averages drop to 44 from 56, and to 16 from 27).15 As to the possible sources for shocks, while Ireland has a share of manufacturing in GDP about the average of other countries in the EU (30 percent average 1990-94), its agriculture share is relatively large (8 percent), and even more so its export share (71 percent). However, Ireland, together with Luxembourg, has the highest share of trade with countries outside the EU.

59. In addition, decomposing the fluctuations in the Irish GDP, it has been found (Jansson, 1996) that merely 7 percent stem from symmetric shocks and the remainder stem from asymmetric shocks. Other studies, however, find that supply shocks are smaller and the speed of adjustment is much faster in Ireland than the EU average, but that demand shocks are larger and the speed of adjustment slightly fester than EU average (Bayoumi and Eichengreen, 1994, see also Central Bank, 1997). While the results overall appear mixed, they indicate that against the potentially significant benefits of EMU participation there could be (if the United Kingdom does not participate) non-trivial costs for Ireland resulting from giving up the option of adjusting monetary and exchange rate policies in face of adverse shocks.16

E. Common Currency and Internal Flexibility

60. The approach to EMU focuses attention on the structural flexibility of the Irish economy. Despite the impressive recent record of output growth and job creation, rigidities in the factor and product markets remain. Unemployment is declining but from a high level (Chart 5) with long-term unemployment persistently high (about 7 percent of the labor force).



Citation: IMF Staff Country Reports 1997, 077; 10.5089/9781451818697.002.A002

Sources: CSO. Labour Force Survey; and OECD, Main Economic Indicators.1/ 1997 is projected for Ireland.

61. In the absence of exchange rate adjustments and independent monetary policies, the labor market will have to absorb the bulk of adjustment following an economic shock.17 In addition, disciplined by the Growth and Stability Pact calling for budget balance or small surplus in normal times, fiscal policy may not be able to respond fully to adverse shocks.18 Consequently, labor market flexibility is critical to ensuring the economy’s resilience to shocks. While labor supply in Ireland is relatively elastic, reflecting migration flows and the scope for further increases in female participation, the challenge will be to assure that Irish wage levels are adequately flexible in response to shocks.

62. Both in August 1986 and January 1993 sterling weakness against ERM currencies proved to be a decisive factor forcing the Irish pound to be devalued within the EMS, highlighting the need to bolster the Irish economy’s ability to accommodate sharp swings in sterling. Moreover, to the extent that dependence on United Kingdom inflation19 remains once Ireland enters EMU, it could complicate stabilization and adjustment following a significant shift in the sterling/euro exchange rate. However, the adjustment challenge would be mitigated to the extent that the regime change associated with EMU results in a structural break in price and wage-setting behavior in Ireland.

63. Also, Ireland’s very open trade regime serves as an important stabilizer (Chart 4). A temporary decline in supply or a temporary rise in demand for goods would lead to a rise in net imports which stabilizes consumption and likely output. The more open the economy, the larger the response of net imports as a percent of GDP, and correspondingly, the smaller the required changes in terms-of-trade.


A1. Movements in the Irish pound, sterling and DM.

The responsiveness of the Irish pound to monthly changes in the sterling and deutsche mark (DM) respectively is measured by the estimated β-parameters in equation (Al) below. Monthly data is taken from International Financial Statistics (IFS) (ae) and the currencies are expressed in units of U.S. dollar (end-of-period).


The own lags are included to help produce well behaved residuals. Except for the sample periods including the currency crises of 1992, the residuals are normally distributed, with no autocorrelation or ARCH effects.

A2. Correlation of industrial production

To investigate the correlation of industrial production among EU-countries in the two different samples, the empirical application proceed in two steps. First, it involves applying the Hodrick-Prescott (HP) filter to the log of seasonally adjusted quarterly industrial production data (1969:1-96:1) with the smoothing parameter set at the standard value of 1600. Data is taken from IFS. Second, the pair wise correlation coefficients (times 100) of the cyclical components are calculated, i.e., actual production less the estimated trend component (y-y*).

Shocks to industrial production are identified with the residuals in the following equation estimated by OLS.


The results are presented in Tables 4 and 5. The volatilities of the cyclical component and the shocks (reported in parenthesis in the Tables) are measured by the standard deviation.


  • Central Bank of Ireland (1997), Ireland’s Participation in EMU: A Further Economic Assessment,” memo.

  • Eichengreen B. (1996), EMU: An Outsider’s Perspective, Center for Economic Research Working Paper Series, WP96/26

  • Eichengreen B., and T. Bayoumi (1994), One money or many?: analyzing the prospects for monetary unification in various parts of the world, Princeton studies in International Finance no. 76.

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  • Frankel J., and A. Rose (1996), Economic structure and the decision to adopt a common currency, CEPR Discussion paper 1473.

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Prepared by Lars Meuller.


Based on swap interest rates (published in Financial Times, May 27) the market assigns a probability of 75 percent that Ireland enter EMU in January 1999, compared to 59 percent four weeks earlier.


For a more comprehensive review of the Irish pound in the ERM, see “Ireland’s Trade and Financial Links with the United Kingdom” in SM/96/140 (June 17, 1996).


The central bank had indicated in its spring policy statement that policy should be tightened would the effective exchange rate move lower.


There are two conflicting views regarding whether the income correlation is likely to go up or down, as the result of linking the currencies. Empirical results in Frankel and Rose (1996) suggest that the positive effect dominates and that the relationship between trade and income correlation is robust to various measures of income (GDP, industrial production, consumption, etc.) and de-trending methods.


Analysis by Eichengreen (1996) suggests that Ireland has converged in economic structure and trade orientation toward the EU core between 1987 and 1995.


Industrial production is chosen as the measure of economic activity on the basis of a sufficiently long and large sample of a consistently defined variable.


Ireland is one of few countries where the volatilities of the shocks to production, as measured by the standard deviation of the estimated residuals, have increased in the later sample.


This consideration is also reflected in the ESRI computations of costs resulting from economic shocks (section C).


Strictly speaking, adjustment refers to a new equilibrium following a permanent shock as opposed to stabilization to the same equilibria following a temporary shock. The former requires either movements in relative prices and wages or movements in labor and capital. In the case of stabilization, however, changes in term-of-trade would mitigate the shocks, just as in the case of adjustment, but movements in productive factors should be avoided.


Gtven that the pact is formulated in levels of GDP, it imposes a tighter discipline on countries such as Ireland with high trend growth rates (see SM/97/138, Appendix IV).


Two recent studies on Irish consumer price inflation and wages, using multivariate cointegration techniques have a contrasting focus. The ESRI (1996), indicates that both Irish prices and wages can largely be explained by developments in the United Kingdom; and that the degree of nominal price inertia is suggested by estimates showing that nominal prices and wages takes three to four years to folly adjust in response to a sterling shock. In contrast, analysis by Kenny and McGettigan (1997) points to the strong role played by the nominal effective exchange rate and foreign prices for Irish consumer price inflation; and the stable relationship between Irish wages and aggregate consumer prices.

Ireland: Selected Issues
Author: International Monetary Fund