Will the emergence of the euro lead to greater or less international monetary stability? And will the euro’s exchange rate against other major currencies be more or less stable than the current rates of European currencies against the dollar? In the short term, as portfolio adjustments take place, many economists argue that there may be a lot of instability. This is illustrated by current uncertainties about the future dollar-euro exchange rate.

But what about the longer term, when the portfolio adjustments have taken place? Will the internal exchange rate volatility eliminated by EMU be transferred to the euro exchange rate? Or will the creation of a large euro zone make both monetary policies and the exchange rate itself more stable? Recent CEPR research addresses these questions.

One way to analyse the euro’s likely volatility is to start from a known fact: the ‘size effect’ of EMU. The size of the zone created by EMU will be bigger (far bigger in the case of the full EU-15) than any individual member. This means that from a macroeconomic perspective, the EMU zone will be less open. If EMU included all EU member states from the start, the zone’s degree of openness would be similar to that of the US and Japan: 12% for the EU-15, compared to 10.5% for the US and 9.5% for Japan.

This size effect will certainly lead the European Central Bank (ECB) to attach less importance to the euro’s exchange rate against the dollar. Since exchange rate changes have a smaller impact on the domestic price level in a large country, the ECB will probably follow a policy of ‘benign neglect’, rather like the current policy of the Federal Reserve. The Bank may also care less about the trade and output consequences of changes in the exchange rate.

Daniel Cohen uses this mechanism to argue that the euro will be more volatile than existing European currencies (Cohen, 1997). To illustrate his argument, one can compare the reactions of the Fed and the central banks of Europe to the recession of the early 1990s. Whereas in the US the Fed didn’t hesitate to lower interest rates aggressively, the European central banks reacted much less strongly, in part because of their fear of the consequences both for bilateral exchange rates and for the exchange rate with the dollar.

Cohen argues that since such concerns will be eliminated or at least reduced with EMU, monetary policy and fiscal policy may be more reactive to domestic shocks and therefore more unstable. With perfect capital mobility, this in turn will lead to more unstable exchange rates.

On the other hand, as I argue (Martin, 1997), a large country has less incentive to use its monetary policy strategically to stabilize its economy than a small country. Again, this is because output of the former depends less on the exchange rate than output of the latter. Reduced use of the exchange rate as a strategic instrument should lead to a more stable exchange rate. From that point of view, the euro should be a more stable currency.

It is clear that theoretical arguments can be used to substantiate scenarios of both higher and lower euro volatility. An examination of existing relationships between country size and exchange rate variability for OECD countries may help clarify the matter.

In my recent paper, I find a strong positive relationship between size and volatility for relatively small countries. But the relationship is non-linear and appears to be reversed for large countries. In other words, the larger a large country, the less volatile its currency. Since EMU will entail the creation of a very large monetary zone, my empirical model actually predicts a small decrease in nominal exchange rate variability. This decrease should be more significant the larger the monetary union.

Cohen’s paper approaches the problem rather differently, focusing on real exchange rates and simulating the reaction of the ECB to different shocks. Under a scenario where monetary policy is bolder because the Bank is less concerned about trade imbalances, he finds an increase in the volatility of the real exchange rate.

Even though researchers disagree on the impact of the euro on exchange rate volatility, they are united on the welfare implications. With a weaker exchange rate constraint, large countries are able to focus more on domestic stabilization of output and inflation. If EMU generates increased exchange rate variability because of ‘benign neglect’, this would only reflect the fact that monetary policies will react more, and more optimally, to domestic shocks.

So from a purely macroeconomic point of view, the scenario of increased exchange rate volatility under EMU should not be of great concern. The microeconomic consequences, however, may be less welcome, obliging European industries to reinforce their hedging strategies, either through financial engineering or relocation.

Philippe Martin
Assistant Professor, Graduate Institute of International Studies, Geneva, and Research Affiliate in CEPR’s International Macroeconomics and International Trade programmes