OPTIMUM CURRENCY AREAS AND EUROPEAN MONETARY UNIFICATION

I. INTRODUCTION The process of European unification took a new turn in December 1991, when political leaders approved the Maastricht Treaty, which committed the European Community (EC) to a single currency and a common Central Bank in three steps. First, members would coordinate their monetary policies. Second, a European Monetary Institute would be set up to study the convergence in macroeconomic indicators and act as a precursor of a common European Central Bank. The third step would involve creating a single currency starting January 1997 if convergence criteria are met; otherwise a single currency would be issued in January 1999 by countries that meet the convergence criteria. There are several potential benefits of currency union membership. First, it would bring maximum credibility to exchange rate stability by eliminating risks and transaction costs stemming from exchange rate operations inside the currency union. Such stability would enhance specialization and optimal allocation of capital. Second, members might obtain some efficiency gains by avoiding negative externalities associated with beggar-thy-neighbor type policies. Finally, as stressed recently by Bofinger (1993), a currency union might enable monetary authorities to pursue monetary control more effectively as a result of money demand becoming more stable in a wider area under open capital markets and full financial liberalization. While these and other potential benefits might dominate for a particular country or region, costs of membership mostly involve reduced policy independence. Policy independence is crucial if a given country faces idiosyncratic disturbances. Particularly, if countries that comprise the European Union (EU) show inadequate symmetry in their business cycle, individual countries would be better off retaining their ability to conduct monetary/exchange rate, and/or fiscal policies. Eventually if unification proceeds without adequate macroeconomic convergence, a centralized decision making might result in "average performance" while a competitive approach might allow convergence to the best practice. Thus an important empirical question is whether Europe is a region where country-specific, idiosyncratic shocks prevail or whether it is a region where shocks affect all countries in a rather similar way. Another related question is whether European countries have significantly different macroeconomic policy practices, which among other things, might have important implications for the single currency in terms of seigniorage. Recall that one advantage of a national money is that it enables the policymaker to raise revenue through the inflation tax. Cohen and Wyplosz (1989), Bayoumi and Eichengreen (1992), Chamie et al. (1994), and Whitt (1995) recently addressed the first question. This paper's main objective is to re-examine monetary unification in Europe from an optimum currency areas perspective. The paper follows Blanchard and Quah (1989) by distinguishing between supply shocks, real fiscal (demand) shocks, and nominal shocks and analyzes the symmetry and incidence in order to assess possible adjustment problems of a single currency. Moreover, "identification" of real fiscal impulses has an important bearing on another aspect of monetary unification, namely the ability to use the inflation tax. The literature on exchange rate regimes alludes to fixed rates as providing discipline to policymakers (Giavazzi and Pagano, 1988; Aghevli et al., 1991; Frenkel et al., 1991). Accordingly, fixing the exchange rate against a country committed to low inflation can be viewed as a pledge not to make heavy and discretionary use of the seigniorage tax. De Kock and Grilli (1989; 1993) show that the losses associated with participating in a monetary union increase with the variance of government spending shocks. This stems from the fact that higher variability of government spending in a flexible exchange rate system allows the use of seigniorage to smooth the time profile of distortionary taxes. …