Accession to the euro-area: a stylized analysis using a NK model

Abstract

This paper analyses the accession to the euro-area by new members using a stylized new-Keynesian model. We analyze macroeconomic adjustment in the pre- and post-accession case and calculate welfare in both situations to obtain net benefit/loss from accession. It is shown how the effects of accession is related to the conduct of monetary policy and fiscal policy in the pre- and post-accession case. The simulation examples point at the potential costs that accession might entail due its consequences on monetary and fiscal policy design. These consequences from accession in terms of macroeconomic stabilization ability of monetary and fiscal policies have not always been fully acknowledged and may need more attention.

This is a preview of subscription content, access via your institution.

Fig. 1
Fig. 2
Fig. 3
Fig. 4
Fig. 5

Notes

  1. 1.

    Also for Bulgaria and Romania that will enter the EU on January 1, 2007 entering the EA will become a relevant aspect in the medium to long term.

  2. 2.

    In addition there are a number of additional effects that are ignored in this paper. These relate in particular to changes in the area of policy coordination in the EA and decision making inside the ECB. Accession changes the strategic settings and the possibilities for cooperation of policies for both acceding and existing member states. For the common central bank, the accession of additional countries, implies that: (1) there is a redefinition of the aggregate target variables; this by itself may already induce changes in optimal policymaking; (2) its preferences may change if the acceding countries have different preferences; this will affect policymaking; (3) the strategic configurations (coalition formation process) in which the common central bank operates have changed: the number of fiscal players in the monetary union increases and the number of outside monetary and fiscal players decreases. The adjustment dynamics from exchange rate adjustment are changed.

  3. 3.

    Output and output gap in fact can be used interchangeably as long as equilibrium output remains constant. Note that in a transition/accession context, it is very hard and arbitrary to determine such longer term equilibrium variables like potential output \(\overline y _t \) and equilibrium real interest rate \(\overline {r_t } \) since these will be subject still to changes over time, e.g. due structural breaks, an ongoing catching up process that introduces a clear deterministic trend in potential output and earlier a gradual disinflation process. In this paper we essentially ignore these aspects and limit ourselves by noting that these aspects are likely to further complicate the accession process and the determination of an optimal monetary and fiscal policy framework for the acceding countries. In that sense our results later on concerning the relative benefits from having national monetary and fiscal autonomy (the pre-accession phase) can be considered as a very conservative lower bound.

  4. 4.

    Net exports are a function of foreign output and price competitiveness: \({\text{net exports}} = \sigma y_t^{\operatorname{EA} } + \delta \left( {e_t + p_t^{\operatorname{EA} } - p_t } \right)\).

  5. 5.

    Leith and Malley (2002), Batini et al. (2003) and McCallum and Nelson (1999) provide micro-foundations for the presence of habit formation in consumption. Empirical evidence is provided that the backward looking component in consumption is substantial.

  6. 6.

    See e.g. Gagnon and Ihrig (2002), Leitemo et al. (2002), Coenen and Wieland (2002) that use similar open economy Phillips curves.

  7. 7.

    In technical terms the commitment solution follows the maximum principle or Hamiltonian approach of dynamic optimal control and the discretion solution the dynamic programming approach.

  8. 8.

    Discretionary policies will also induce an inflationary bias in case the policymaker chooses an output objective that exceeds the potential output, reflecting e.g. the case of a dependent Central Bank that is steered by political objectives. In the remainder of this study we will, however, not deal with such cases.

  9. 9.

    Note that in our analysis, we will assume that exchange rate expectations are always set in an entirely forward-looking manner.

  10. 10.

    See e.g. Dvorsky (2000) on CB independence in the countries in Central and Eastern Europe.

  11. 11.

    While the absence of any own empirical estimations may seem a bit unsatisfying this type of analysis based on calibrated parameters and/or parameters that appears plausible from empirical studies, is quite common in NK papers. See e.g. Jensen (2002) that follows this line of thought and analysis and refers to “compromise values” when choosing parameter values that would seem plausible for the US case in his analysis.

  12. 12.

    Another aspect that needs to mentioned is that even inside the group of accession countries there are likely to be asymmetries in terms of economic structures and macroeconomic shocks so that our approach here of modeling only one representative accession country (or the alternative interpretation that all the accession countries are lumped together here into one small accession country) implies severe implications when the results are applied to reality where the accession process is even more complex. Probably such heterogeneity in reality would further strengthen the case for a very cautious accession process.

  13. 13.

    Note that we ignore the benefits from accession in the form of lower transaction costs and other microeconomic efficiency gains, if these would amount to some amount Δ% we could subtract that amount from the OCA index to get the overall amount of net losses. Since we have no concrete estimate of Δ it is ignored in the analysis. Empirical studies suggest that these efficiency gains are typically in the range of 1–5% of GDP.

  14. 14.

    Note that these indices are dimensionless, they do not provide information concerning e.g. the costs/benefits of accession in terms of foregone/increased GDP as is sometimes tried in empirical studies.

References

  1. Backé P, Thimann C, Arratibel O, Calvo-Gonzalez O, Mehl A, Nerlich C (2004) The acceding countries’ strategies towards erm ii and the adoption of the euro: an analytical review. Occasional paper series no. 10

  2. Battini N, Harrison R and Millard S (2003) Monetary policy rules for an open economy. Journal of Economic Dynamics and Control 27: 2059-2094

  3. Bayoumi T, Kumhof M, Laxton D, Naknoi K (2005) Exchange rate regimes, international linkages, and the macroeconomic performance of the new member states. In: Detken C, Gaspar V, Noblet G (eds) The new EU member states. Convergence and stability. European Central Bank, Frankfurt, pp 121–171

    Google Scholar 

  4. Boone L, Maurel M (1999) An optimal currency area perspective of the EU enlargement to the CEECs. CEPR Discussion Paper no. 2119

  5. Ca’ Zorzi M, De Santis R, Zampolli F (2005) Welfare implications of joining a common currency. ECB Working Paper Series No. 445

  6. Clarida R, Gali J, Gertler M (1999) The Science of monetary policy: a new Keynesian perspective. J Econ Lit 37:1661–1707

    Google Scholar 

  7. Coenen G, Wieland V (2002) Inflation dynamics and international linkages. A model of the United States, the Euro Area and Japan. Board of Governors of the Federal Reserve System, International finance discussion papers no.745

  8. Devereux M (2003) A macroeconomics analysis of EU accession under alternative monetary policy. J Common Mark Stud 41(5):941–964

    Article  Google Scholar 

  9. Dvorsky S (2000) Measuring central bank independence in selected transition countries, OENB Focus on Transition 2/2000.

  10. Fidrmuc J, Korhonen I (2003) Similarity of supply and demand shocks between the euro areas and the CEECs. Econ Syst 27:313–334

    Article  Google Scholar 

  11. Fuhrer J, Moore G (1995) Monetary policy trade-offs and the correlation between nominal interest rates and real output. Am Econ Rev 85(1):219–239

    Google Scholar 

  12. Gagnon J, Ihrig J (2002) Monetary policy and exchange rate pass-through, mimeo.

  13. Giordani P (2004) Evaluating new-Keynesian models of a small open economy. Oxf Bull Econ Stat 66:713–733

    Article  Google Scholar 

  14. Hughes Hallett A, Lewis J (2005) Hansa vs habsburg: debt deficits and the entry of accession countries into the Euro. CEPR Discussion Paper no.4500.

  15. Huh C, Lansing K (2000) Expectations, credibility, and disinflation in a small macroeconomic model. J Econ Bus 51(1–2):51–86

    Article  Google Scholar 

  16. Jensen H (2002) Targeting nominal income growth or inflation? Am Econ Rev 92(4):928–956

    Article  Google Scholar 

  17. Leitemo K, Roisland O, Torvik R (2002) Time inconsistency and the exchange rate channel of monetary policy. Scand J Econ 104(3):391–397

    Article  Google Scholar 

  18. Leith C, Malley J (2002) Estimated general equilibrium models for the evaluation of monetary policy in the US and Europe. CESifo Working Paper no.699

  19. McCallum B, Nelson E (1999) Nominal income targeting in an open-economy optimizing model. Journal of Monetary Economics 43: 553-578

    Article  Google Scholar 

  20. Muscatelli VA, Tirelli P, Trecroci C (2004) Fiscal and monetary policy interactions: empirical evidence and optimal policy using a structural new-Keynesian model. J Macroecon 26:257–280

    Article  Google Scholar 

  21. Natalucci F, Ravenna F (2002) The road to adopting the Euro: monetary policy and exchange rate regimes in EU candidate countries, board of governors of the federal reserve system, international finance Discussion Papers No. 741

  22. Svensson L (2000) Open-economy inflation targeting. J Int Econ 50:155–183

    Article  Google Scholar 

  23. Taylor J (2000) Reassessing discretionary fiscal policy. J Econ Perspect 14(3):21–36

    Article  Google Scholar 

  24. von Hagen J, Traistaru I (2005) Macroeconomic adjustment in The New EU Member States. In: Detken C, Gaspar V, Noblet G (eds) The New EU Member States. Convergence and stability third report. European Central Bank

  25. Woodford M (2003) Interest and prices: foundations of a theory of monetary policy. Princeton University Press, Princeton

    Google Scholar 

Download references

Author information

Affiliations

Authors

Corresponding author

Correspondence to Bas van Aarle.

Rights and permissions

Reprints and Permissions

About this article

Cite this article

van Aarle, B., Garretsen, H. & Moons, C. Accession to the euro-area: a stylized analysis using a NK model. Int Econ Econ Policy 5, 5–24 (2008). https://doi.org/10.1007/s10368-008-0107-y

Download citation

Keywords

  • Euro-area
  • Fiscal policy
  • Monetary policy

JEL Classification

  • F31
  • F41
  • G15