Who will join EMU? Impact of the Maastricht convergence criteria on economic policy choice and performance

To qualify for European Monetary Union (EMU) countries must meet convergence criteria established in the Maastricht treaty of December 1991. However, an analysis of how difficult it will be to meet the convergence criteria is not sufficient to identify the countries most likely to join EMU in 1999. This paper identifies a number of factors in addition to budget deficit reduction required to qualify for EMU such as; the persistence of inflationary expectations; the variance of output shocks; the inflationary bias to monetary policy; and, the political cost to not joining EMU. Moreover, countries follow a policy rule where a large negative output shocks can cause them to abandon the restrictive policies necessary to qualify for EMU and, instead, use policy for stabilization. Concern about such a policy shift could cause increases in interest rates similar to those observed during ERM crises. Data on the above factors are generally not available, except for budgetary data. However, the model shows that data on long-term interest rate differentials with Germany can serve as a measure of their influence. Two approaches, using implied forward interest rate differentials and econometric analysis, are used to evaluate the usefulness of this measure. Both support the use of long-term interest differentials. Overall, it appears likely that EMU will occur in stages as factors are relatively favorable for EMU in Denmark, France, Ireland and the Netherlands. In contrast, for Italy and Spain EMU appears unlikely.