EMU, Adjustment, and Exchange Rate Variability

Abstract

This is a Working Paper and the author(s) would welcome any comments on the present text. Citations should refer to a Working Paper of the International Monetary Fund. The views expressed are those of the author(s) and do not necessarily represent those ofthe Fund.

The Euro and International Capital Markets

“…The empirical exercise undertaken seems to suggest that the euro area is within that downward sloping part of the "size-volatility curve". Ricci and Isard (1998) show that the development of euro exchange rate volatility can go either way, entirely depending on what type shocks hit the euro area economy. Coutinho (1999) adds that grouping countries with different economic structures into one currency union might be different from the increase in size of a given economy, since the combination of symmetric and asymmetric shocks might be different in both cases.…”

“…Later the discussion was basically re-balanced. Theoretical models by Martin (1998), Ricci and Isard (1998) and Coutinho (1999), for example, show that euro volatility could well also be lower rather than higher. In Martin's (1998) model a "hump-shape" relationship between the internal size of a currency area and exchange rate volatility emerges.…”

Capital Controls

“…Bayoumi and Eichengreen (1998) find that pressures on the exchange rate mainly reflect asymmetric shocks, whereas intervention reflects a country's small size and large trade links-the variables that cause countries to value stable exchange rates according to OCA theory. 7 Ricci and Isard (1998) show that the relative variability (against external currencies) of the euro and a basket of predecessor currencies depends on the relative sizes of countries, their sectoral patterns of trade, and the relative importance of different shocks. 8 Much of the recent work on currency unions at the IMF has focused on whether particular groups of countries have the requisite economic and institutional characteristics for the successful operation of a currency union.…”

The Euro and International Capital Markets

“…Will the euro be more or less volatile than its predecessor currencies, in particular the mark? This question caused an extensive debate before the start of stage 3, with Alogoskoufis and Portes (1997), Bénassy et al (1997), Bergsten (1997) and Cohen (1997) pointing to possible larger amplitudes of euro exchange rate adjustments in response to macroeconomic shocks, and Martin (1998), Ricci and Isard (1998) and Coutinho (1999) making the case that euro volatility could well be lower rather than higher. Putting the different arguments in the literature together, there is no strong theoretical case in favour of either direction.…”