Monetary Integration in Europe: Implications for Real Interest Rates, National Stock Markets and the Volatility of Prices and Exchange Rates

Monetary arrangements in Europe vacillated wildly over the last decade, and they may be expected to continue to do so over the next. The literature on this chaotic process has focused on issues of credibility. Here, we focus instead on the longer-run implications of Europe's choice of monetary regime, after the noise and confusion has abated. Changing the way transactions are made - that is, which currencies are used to buy what goods, and which currencies are linked to one another by official intervention - changes the way prices and exchange rates fluctuate in response to real and nominal shocks, and therefore their stability. Transaction patterns also determine the correlation between prices and consumption, which in turn affects real interest rates and the stock market via the risk premium. And finally, the changes in inflationary expectations that may accompany these regime switches can have an impact on the stock market via the seignorage tax. In this paper we calibrate a simple general equilibrium model to assess the impact on Germany, France, Italy and the United Kingdom of the process of monetary integration in Europe - starting with a flexible rate regime, passing through a hard EMS, and ending in EMU, with periods of flexible rates along the way.