External Effects of Currency Unions

WZB Markets and Political Economy Working Paper No. SP II 2004-06

35 Pages Posted: 3 Jul 2004

See all articles by Thomas Pluemper

Thomas Pluemper

Vienna University of Economics and Business - Department of Socioeconomics; University of Essex - Department of Government

Vera E. Troeger

University of Essex - Department of Government

Date Written: April 2004

Abstract

Argument: The paper argues that the introduction of the Euro has considerably reduced de facto monetary policy autonomy in non-ECU members.

We start from a simple Mundellian model, in which currency unions raise economic efficiency but reduce monetary policy autonomy. Our main argument holds that governments in countries that did not join the currency union lose monetary policy autonomy if the establishment of a currency union increases the size of the key currency area. The increase in the size of the key currency area has two external effects on countries remaining outside the currency union: Firstly, it renders stable exchange-rates to the currency union slightly more important, because the value of goods imported from countries within the currency union increases and because the countries inside the union have more synchronized business cycles. Secondly and more importantly, we claim that any given change in the real interest-rate differential leads to an exchange-rate effect, which is larger the smaller the domestic currency area is relative to the key currency area. Consequently, governments in non-member countries have to pay a higher price if they seek to stimulate the domestic economy.

Hypotheses: a) Exchange-rate effects on changes in the real interest rate differential are larger, if currency areas are less equal in size. b) Outsider countries more closely follow the interest-rate policy of the currency union than they had previously followed the monetary policy of the anchor currency. Empirics: We employ a panel-GARCH model to estimate the impact of changes in the key currency real interest rate on the real interest rate of other countries. Specifically, we analyze the influence of Germany's and the Eurozone's monetary policy on the monetary policy of Great Britain, Denmark, Norway, Sweden, and Switzerland.

Results: Our results support the assumptions underlying our model as well as our main argument. De facto monetary autonomy of countries remaining outside a currency union declines with the establishment of the union.

Keywords: Interest Rates, Monetary Policy Autonomy, Currency Unions, Bundesbank, European Central Bank

JEL Classification: E5, N1

Suggested Citation

Plümper, Thomas and Troeger, Vera E., External Effects of Currency Unions (April 2004). WZB Markets and Political Economy Working Paper No. SP II 2004-06. Available at SSRN: https://ssrn.com/abstract=540022 or http://dx.doi.org/10.2139/ssrn.540022

Thomas Plümper (Contact Author)

Vienna University of Economics and Business - Department of Socioeconomics ( email )

Vienna
Austria

University of Essex - Department of Government ( email )

Wivenhoe Park
Colchester, Essex CO4 3SQ
United Kingdom

HOME PAGE: http://www.polsci.org/pluemper

Vera E. Troeger

University of Essex - Department of Government ( email )

Wivenhoe Park
Colchester CO4 3SQ, CO4 3SQ
United Kingdom

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