Zenon G. Kontolemis
The introduction of a single currency in Europe in January 1999 and the changeover to euro notes and coins on January 1, 2002 present new challenges to policymakers. In this context, a sound understanding of the new environment is vitally important. Recent research at the IMF on the euro area has been motivated by the need to shed light on a wide range of issues, with a specific focus on providing the tools that will allow policymakers to evaluate the appropriateness of areawide macroeconomic policies. This article provides an overview of this research and focuses on work covering monetary, exchange rate, and fiscal policies.
Since the beginning of Stage Three of European Economic and Monetary Union (EMU) in January 1999, the European Central Bank (ECB) has conducted monetary policy at the euro-area level. The ECB’s framework, which aims at preserving price stability in the euro area, consists of a two-pillar strategy.
Under the first pillar, the ECB announces a reference value for the growth of the monetary aggregate M3 and revises it annually. This reference value serves as a guidepost for developments in the monetary sector in that any persistent deviations from that value signal risks to price stability. The underlying assumption is that a stable money demand for the euro area exists. This has motivated research at the IMF on examining the stability of euro-area money demand and the appropriateness of the ECB’s reference value (Calza, Gerdesmeir and Levy, 2001; Kontolemis, 2001).1 More specifically, Kontolemis (2001) shows that the reference value for M3 growth chosen by the ECB is somewhat low, based on recent trends, and argues that—given the uncertainty relating to velocity trends—a monitoring range may be more desirable, from a communication viewpoint, than a point reference value.
Under the second pillar, the ECB monitors a wide range of other economic indicators—including output developments—that may contain information regarding risks to price stability. In this respect, the measurement of the output gap is crucial for policymakers. Ross and Ubide (2001) provide one of the first attempts to measure the euro-area output gap.2 In addition to comparing different measures of the output gap, their paper assesses how these compare in forecasting inflation and in mimicking the properties of coincident measures of the business cycle.
Understanding the monetary policy transmission mechanism in the common currency area is, of course, crucial for the ECB. Research at the IMF has focused on measuring and explaining differences in the transmission mechanism of monetary policy across countries (for example, Ramaswamy and Sloek, 1998), and drawing implications for policymaking at the euro-area level.3 Clements, Kontolemis, and Levy (2001) observe that the large differences in the responses of prices and output to (unanticipated) changes in interest rates, across the 12 countries cited in earlier research, reflected both differences in the countries’ monetary frameworks prior to adopting the euro, as well as differences in the monetary policy transmission mechanisms as such.4 The study attempts to isolate and explain differences that are due to the transmission mechanisms themselves, and hence are likely to persist under EMU.5 By taking into account the new institutional framework of EMU—fixed intra-euro-area exchange rates and a common monetary policy across countries—the study provides a better measure, than earlier work, of the effects of (unanticipated) monetary policy changes on prices and output for the euro area as a whole and across countries. Moreover, the study shows that differences in the financial systems across euro-area countries are important and explain some of these differences in the transmission mechanism. In a related study, Belaisch, Kodres, Levy and Ubide (2001) provide an in-depth look of the banking system in the euro area and highlight some of the differences across countries.6
In this uncertain environment, the continuing weakness—and unpredictability—of the euro exchange rate has complicated the formulation of monetary policy. A recent contribution by Meredith (2001) attempts to explain the sources of the depreciation of the euro since January 1999.7 This paper argues that the depreciation of the euro since the introduction of the common currency is a continuation of a trend observed since the mid-1990s. This trend is largely explained by the strong performance of the U.S. stock market since the beginning of the 1990s, relative to Europe, and is not the consequence of the introduction of the euro as such.8 The surge in equity prices since the mid-1990s created a demand shock that disproportionately affected the United States. More recently, the fall in the euro is also attributed to (global) portfolio shifts that followed the introduction of the new currency. Hence, the ECB’s monetary policy actions are not considered directly related to the decline in the exchange rate value of the euro, and should remain focused on the broader macro-economic environment rather than on exchange rate considerations.9
Fiscal policy remains highly decentralized across the 12 euro-area countries, although countries are required to abide by the rules of the Stability and Growth Pact (SGP). According to the SGP, countries are committed to achieving sound fiscal positions by adhering to a medium-term budgetary objective of “close to balance or surplus.” Work at the IMF dating back to 1997 discusses the institutional setup of the SGP (see Begg, 1997, for example) and its ability to overcome a past procyclical bias, which was an unfortunate historical characteristic in many euro-area countries (Jaeger, 2001, for example).10 Indeed, recent work in this area focuses on asymmetric fiscal policy behavior over the cycle and the way that institutions, including the SGP, can prevent this practice. Related research by Detragiache, Milesi-Ferretti, Daban, and Symansky (2001) explores the benefits of rules-based approaches to fiscal policymaking in the four largest economies of the euro area and argues that countries should place more emphasis on spending rules within the SGP.11
In addition, recent IMF research on the euro area has also addressed other related issues. Decressin, Estevao, Gerson, and Klingen (2001) demonstrate that output growth in France, Germany, Italy and Spain, during the last expansion, has been more employment intensive than during previous growth episodes and argue that this is a result of sustained wage moderation in the euro area.12 Finally, Ford and Gerson (2001) examine the policy implications of inflation differentials in the euro area, and conclude that in cases where such differentials are not driven by macroeconomic fundamentals such as productivity differentials, fiscal policy is a more appropriate means to offset them.13
A. Calza, D. Gerdesmeier, and J. Levy, “Euro Area Money Demand: Measuring the Opportunity Costs Appropriately,” IMF Working Paper No. 01/179, 2001; Z. G. Kontolemis, “The ECB’s Monetary Stance: First Pillar Considerations,” IMF Country Report, No. 01/201,2001.
K. Ross, and A. Ubide, “Mind the Gap: What Is the Best Measure of Slack in the Euro Area?” IMF Working Paper No. 01/203, 2001.
R. Ramaswamy and T. Sloek, “The Real Effects of Monetary Policy in the European Union: What Are the Differences?” IMF Staff Papers, Vol. 45, No. 2, pp. 374–95, 1998, (Washington: International Monetary Fund).
B. Clements, Z. G. Kontolemis, and J. Levy, “Monetary Policy Under EMU: Differences in the Transmission Mechanism?” IMF Working Paper No. 01/102, 2001.
A related paper that covers the four largest countries in the euro area is M. Ciccarelli, and A. Rebucci, “The Transmission Mechanism of European Monetary Policy: Is There Heterogeneity? Is it Changing over Time?” forthcoming IMF Working Paper.
A. Belaisch, L. Kodres, J. Levy, and A. Ubide, “Euro-Area Banking at the Crossroads,” IMF Working Paper No. 01/28, 2001.
G. Meredith, “Why Has the Euro Been So Weak?” IMF Working Paper No. 01/155, 2001.
Another contribution discussing the degree of capital market integration across euro-area countries and the implications for future capital flows within the euro area is J. Decressin and P. Disyatat, “Capital Markets and External Accounts: What to Expect from the Euro,” IMF Working Paper No. 00/154, 2000.
A number of contributions by IMF staff on the euro are also included in the volume by P. Masson, T. Krueger, and B. Turtelboom, eds., EMU and the International Monetary System (IMF: Washington DC, 1997).
D. Begg, “The Design of EMU,” IMF Working Paper No. 97/99, 1997; A. Jaeger, “Cyclical Fiscal Policy Behavior in the EU Countries,” IMF Country Report No. 01/201, 2001.
E. Detragiache, G. M. Milesi-Ferretti, T. Daban, and S. Symansky, “Rules-Based Fiscal Policy and the Fiscal Framework in France, Germany, Italy, and Spain,” IMF Country Report No. 01/203, 2001.
J. Decressin, M. Estevao, P. Gerson, and C. Klingen, “Job Rich Growth in Europe,” IMF Country Report No. 01/203, 2001.A related paper discussing the issue of high and persistent rates of unemployment in Europe is “Chronic Unemployment in the Euro Area: Causes and Cures,” IMF World Economic Outlook, May 1999.
R. Ford, and P. Gerson, “Cyclically Advanced Euro-Area Economies: Consequences and Policy Options,” IMF Country Report No. 01/95, 2001.