Working Paper: CEPR ID: DP1741
Authors: George Alogoskoufis; Richard Portes; Helene Rey
Abstract: *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 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 transaction 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 assess 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 significent benefits for the euro area, at the cost of the United States 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-à-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 ? 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.
Keywords: euro; international money; exchange rates; EMU; vehicle currency
JEL Codes: F3; F4; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| deeper and more liquid euro securities markets (G15) | reduce transaction costs (D23) |
| reduce transaction costs (D23) | increase attractiveness of euro assets (G15) |
| deeper and more liquid euro securities markets (G15) | increase attractiveness of euro assets (G15) |
| increase attractiveness of euro assets (G15) | appreciation of the euro against the dollar and the yen (F31) |
| development of euro financial markets (G15) | importance of euro as an international currency (F36) |
| thickness externalities in the use of the euro as a means of payment (F36) | importance of euro as an international currency (F36) |
| euro gaining international roles (F36) | cost to the United States and Japan (H56) |
| euro gaining international roles (F36) | dollar remaining quantitatively dominant (F31) |