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The Emergence of the Euro as an International Currency

The European Union will enter Stage Three of Economic and Monetary Union (EMU) in 1999. The development of euro financial markets and thickness externalities in the use of the euro as a means of payment will be the major factors determining the importance of the euro as an international currency. As euro securities markets become deeper and more liquid and transactions costs fall, euro assets will become more attractive, and the use of the euro as a vehicle currency will expand; the two effects interact, as we demonstrate. We use a three-region world model as a framework for alternative steady-state scenarios. With forex and securities market data, we access the plausibility of those scenarios and the implications for economic efficiency (welfare). We find that the euro may take on some of the current roles of the dollar, but the extent to which it does will depend on policy decisions and on the beliefs of market participants. The welfare analysis reveals potential quantitatively significant benefits for the euro area, at the cost of the US and (to a lesser degree) Japan. During the transition to the new equilibrium, the main effect of the introduction of the euro will come through portfolio shifts that are likely to favour an appreciation of the new currency vis-Ó-vis the dollar (and the yen). Whatever the likely long-run outcome, the dollar will remain quantitatively dominant for some time because of inertia and hysteresis û with multiple equilibria and likely threshold effects, we would not expect a quick transition to a new equilibrium. The early period could see considerable instability associated with the emergence of the euro, especially if the United States were to resist any decline in the international status of the dollar.

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Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp0388.

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Date of creation: May 1998
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Handle: RePEc:cep:cepdps:dp0388
Contact details of provider: Web page: http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEP

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