Working Paper: NBER ID: w3684
Authors: Kenneth A. Froot; Kenneth Rogoff
Abstract: When central banks are about to relinquish control over their exchange rate and enter into a currency union, the reptutational costs to devaluation are very low. As with any finite-horizon game, the endpoint affects the earlier expectations of private agents, here causing them to demand higher interest rates and higher wages from countries whose currencies are relatively weak. In looking at the countries within the EMS, we find that Italian long-term interest rates as well as price and wages levels relative to Germany show evidence of growing gaps We also find that the real appreciation of the lira appears to be predominantly due to increases in relative Italian government spending, and not to relatively rapid Italian productivity growth. Taken together, this evidence suggests that convergence within the EMS may have peaked. Furthermore, moving forward the date of currency union may in the short run increase both the growth of the gaps and the need for exchange-rate realignment.
Keywords: European Monetary System; monetary union; real exchange rates; government spending
JEL Codes: E42; F33; F36
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| impending currency union (F36) | interest rates (E43) |
| impending currency union (F36) | wage demands (J31) |
| Italian government spending (H59) | real exchange rate of the lira (F31) |
| interest rates (E43) | wage demands (J31) |
| divergent fiscal policies (E62) | realignments before the union (J51) |