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The Macroeconomic Costs and Benefits of Adopting the Euro

  • Philippe Karam
  • Douglas Laxton
  • David Rose
  • Natalia Tamirisa

This paper uses a two-country version of the global economy model to investigate some costs and benefits of a small, emerging economy's abandoning a flexible exchange rate regime in favor of adopting the currency of its main trading partner. The topic is particularly relevant for countries in central and eastern Europe, which recently joined the European Union and are now preparing to adopt the euro. We begin by evaluating macroeconomic performance in an inflation-targeting regime under various monetary policy rules. The results are then compared with the case where the small economy gives up its flexible exchange rate and joins the monetary union, under a number of alternative assumptions about the magnitude of shocks and structural rigidities. The analysis shows that although the monetary union has the benefit of eliminating exchange rate shocks, the loss of the buffering role of the exchange rate leads to greater volatility in domestic output and inflation. These costs are likely to decline over time, as markets become more competitive, flexible, and integrated in the monetary union. IMF Staff Papers (2008) 55, 339–355. doi:10.1057/imfsp.2008.9; published online 29 April 2008

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Article provided by Palgrave Macmillan in its journal IMF Staff Papers.

Volume (Year): 55 (2008)
Issue (Month): 2 (June)
Pages: 339-355

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Handle: RePEc:pal:imfstp:v:55:y:2008:i:2:p:339-355
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  1. Batini, Nicoletta & Nelson, Edward, 2000. "Optimal Horizons for Inflation Targeting," Working Paper Series 103, Sveriges Riksbank (Central Bank of Sweden).
  2. Alejandro Micco & Ernesto H. Stein & Guillermo Luis Ordoñez, 2003. "The Currency Union Effect on Trade: Early Evidence from EMU," Research Department Publications 4339, Inter-American Development Bank, Research Department.
  3. Alejandro Micco & Ernesto Stein & Guillermo OrdoÒez, 2003. "The currency union effect on trade: early evidence from EMU," Economic Policy, CEPR;CES;MSH, vol. 18(37), pages 315-356, October.
  4. Clark, Peter & Laxton, Douglas & Rose, David, 2001. "An Evaluation of Alternative Monetary Policy Rules in a Model with Capacity Constraints," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(1), pages 42-64, February.
  5. Jeffrey Frankel & Andrew Rose, 2002. "An Estimate of the Effect of Common Currencies on Trade and Income," The Quarterly Journal of Economics, Oxford University Press, vol. 117(2), pages 437-466.
  6. Tamim Bayoumi & Douglas Laxton & Paolo Pesenti, 2004. "Benefits and spillovers of greater competition in Europe: a macroeconomic assessment," International Finance Discussion Papers 803, Board of Governors of the Federal Reserve System (U.S.).
  7. Andrew K. Rose, 2000. "One money, one market: the effect of common currencies on trade," Economic Policy, CEPR;CES;MSH, vol. 15(30), pages 7-46, 04.
  8. Tamim Bayoumi & Hamid Faruqee & Douglas Laxton & Philippe D Karam & Alessandro Rebucci & Jaewoo Lee & Benjamin L Hunt & Ivan Tchakarov, 2004. "GEM; A New International Macroeconomic Model," IMF Occasional Papers 239, International Monetary Fund.
  9. Hamid Faruqee, 2004. "Measuring the Trade Effects of EMU," IMF Working Papers 04/154, International Monetary Fund.
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