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The success of European Economic and Monetary Union (EMU) will depend on the stability of the euro. The monetary policy framework is yet to be decided, but is likely to involve either money or inflation targeting. Stochastic simulations compare the outcomes for major macroeconomic and financial variables pre-and post-EMU under both policy rules, as well as under an inflation targeting rule that includes output. Implications for the euro as a reserve currency are examined in the light of the expected returns and covariances among reserve currencies. The role of the exchange rate as an indicator and incentives for policy coordination with other major countries are also discussed.

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This is a working paper und [he uuthnr would welcome any comments on the present text Citations should refer to an unpublished manuscript, mentioning the author and the date of issuance by the International Monetary Fund. The views expressed are those of the author and do not necessarily represent those of Ihe Fund.

This paper analyzes the recent behavior of real exchange rates, the trade balance and the net foreign asset position of the United States in an intertemporal optimizing model of the world economy that incorporates heterogeneity across countries and imperfect international capital and good markets. While the model successfully tracks the dynamics of trade balances and net foreign assets it generates too much consumption smoothing and excessively volatile relative prices. Resolving these inadequacies simultaneously is difficult as the elasticity of substitution between tradables and nontradables affects in opposite ways the degree of consumption smoothing and the volatility of relative prices.

This paper analyzes exchange rate behavior in a model where consumers trade goods to diversify shocks to their income. A model with traded and nontraded goods is simulated in a multilateral context based upon historical output correlations for the period 1970-92. Simulation results indicate that the observed volatility of multilateral real exchange rates for the United States, Germany and Japan is not inconsistent with exchange rate volatility implied by consumption-smoothing behavior.JEL Classification Numbers: F31, F41, F47 I/ I am very grateful to Peter B. Clark for very detailed comments and discussions, to Tarn Bayoumi, Peter Isard, Douglas Laxton and Thomas Helbling for helpful discussions and to Susanna Mursula, Rosa Vera-Bunge and Jeffery Gable for expert research assistance. The conclusions of this paper are those of the author and are not necessarily those of the International Monetary Fund.

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