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International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page The Road to Adopting the Euro: Monetary Policy and Exchange Rate Regimes in EU Candidate Countries
Fabio M. Natalucci; Federico Ravenna
2002-741  (December 2002)

Abstract:  This paper examines the choice of exchange rate regime in EU candidate countries during the process of accession to the European Monetary Union (EMU). In the presence of real exchange rate appreciation due to the Balassa-Samuelson effect, candidate countries face a trade-off between trend appreciation of the nominal exchange rate and high inflation rates. In a general equilibrium model of an emerging market economy, we show that under a fixed or heavily managed exchange rate the Balassa-Samuelson effect might prevent compliance with the Maastricht inflation criterion, unless a contractionary policy is adopted. We then discuss how the real exchange rate appreciation shifts the output gap/inflation variance trade-off, increasing the cost of managing or fixing the exchange rate. As a consequence, the requirement of membership in the Exchange Rate Mechanism (ERM-II) and the Maastricht inflation criterion constrain the policy choice while providing no additional benefit to countries credibly committed to joining the Euro. Finally, we show that relaxing either the exchange rate requirement or the inflation criterion has sharply different business cycle implications for the accession countries.

Full paper (615 KB PDF)

Balassa-Samuelson Effect, European Union Enlargement, European Monetary Union, Taylor Rule, transition economies

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