A Macroeconomic Analysis of EU Accession under Alternative Monetary Policies

This article provides an analytical discussion of the adjustment to EU accession for an economy under alternative assumptions about monetary policy rules. The post‐accession phase is characterized by rapid capital inflows and real exchange rate appreciation. If accession is combined with membership of the euro area and a pegged exchange rate, then the post‐accession period exhibits excessive foreign borrowing, high wage inflation, an excessive stock market boom, and much too rapid growth in the non‐traded sector at the expense of the exportable goods sector. Alternative monetary policies can be used to eliminate the inefficiencies of the post‐accession adjustment, but some bring real costs in terms of lower growth and unemployment. We find that the best policy is one of flexible inflation targeting with some weight on exchange rate stability. In the absence of exchange rate adjustment, fiscal policy could be used, but this requires complicated time‐varying expenditure taxes. While the analytical discussion emphasizes the benefits of exchange rate adjustment, a later section of the article explores some more recent arguments regarding non‐traditional costs of exchange rate volatility.