MONETARY INTEGRATION, INFLATION CONVERGENCE AND OUTPUT SHOCKS IN THE EUROPEAN MONETARY SYSTEM

I. INTRODUCTION The Maastricht treaty of 1992 outlines a plan for the Economic and Monetary Union (EMU) of members of the European Monetary System (EMS). The treaty provides for a European central bank, and ultimately a single monetary unit. As a preliminary to a single currency, the EMS established a system of fixed exchange rates among its members. Over the long run, for such a fixed exchange rate regime to be sustainable - and a single currency feasible - the monetary policies of the members cannot be highly divergent. Thus, the treaty requires policy convergence - loosely defined as monetary convergence - from the EMS's members before preceding to monetary union. However, the precise conditions for successful "convergence" are not so clear. As MacDonald and Taylor [1991] point out, a successful EMS requires monetary policy coordination among its member states if balance of payments and competitiveness problems resulting from disequilibrium real exchange rates are to be avoided. Yet, empirical studies of whether the members of the EMS have achieved monetary convergence have reached mixed conclusions (Hafer and Kutan [1994] and MacDonald and Taylor [1991]). This evidence raises questions about whether the EMS has failed to bring about a high degree of monetary convergence, or whether the definition of monetary convergence used in these studies requires refinement. Monetary policies cannot diverge much in a successful monetary union. However, the precise policies needed for success depend upon balance of payments considerations. Convergence in a fixed exchange rate system is ultimately defined by balance of payments equilibrium. We often think of balance of payments equilibrium in terms of inflation convergence; and the Maastricht criteria define convergence as such.(1) When inflation differentials are very large, monetary and inflation convergence will largely coincide, but when inflation differentials are more moderate, inflation convergence may require that monetary growth rates diverge slightly, depending upon differences in output growth, velocity, or shifts in preferences for tradeable goods. The purpose of this paper is to explore whether inflation convergence in the EMS interfered with the goal of monetary convergence, given different trends in output and velocity across member countries. The evidence reported here shows that in a core group of EMS countries inflation rates have converged, but monetary aggregates have not. One reason for the differences in the results of tests of monetary convergence in the EMS is that researchers have failed to condition their tests for monetary convergence upon the appropriate factors.(2) For example, according to a monetary model of the balance of payments, tests of monetary convergence should account for differences in output trends. Velocity differences are important conditioning factors as well. The evidence presented here shows that trends in velocity help explain the lack of monetary convergence in the EMS, while different output trends do not. II. DEFINITIONS OF MONETARY CONVERGENCE Previous studies have defined monetary convergence as the cointegration of similar monetary policy variables (reserve money or interest rates), based upon maximum likelihood estimation techniques developed by Johansen and Juselius [1990]. MacDonald and Taylor [1991] argue that fewer than five different trends in monetary aggregates for a sample of five countries reflects "long run convergence." Thus, according to MacDonald and Taylor, if five countries show evidence of four or fewer trends in money growth, long-run convergence has occurred. Hafer and Kutan [1994] improve upon MacDonald and Taylor's definition by distinguishing partial monetary convergence from full monetary convergence. Partial convergence means that time-series data for five countries would show fewer than five trends in monetary aggregates, but full convergence is defined as one common trend for all five countries in monetary aggregates. …