The possible involvement of Finland in the Stage III of the European Monetary Union would comprise a significant change in the operating environment of the Finnish economy. As a member of the common currency area, Finnish interest and exchange rates would no longer be determined by domestic monetary policy or domestic financial market reactions, but would instead be given by the European Central Bank and the European financial markets. Would this raise the seriousness of business cycles in Finland? This is the question the current report seeks to investigate. In the initial part of this report, we evaluate and assess the existing econometric work on the consequences of the European Monetary Union. Even though empirical work on the topic is ample, it is afflicted with a thin focus. The majority of the study follow a highly simplistic empirical implementation of the traditional Keynesian theory of optimal currency areas and appraise the desirability of a currency union by cross-country correlations of certain macroeconomic variables…
We discover the outcomes attained in those research projects tough to interpret, and debate that – specially when measured in a mixed exchange-rate system as has prevailed in Europe – simple macroeconomic correlations don’t convey any meaningful info on the desirability of a currency union. In the next part we present an alternative method of the empirical analysis of the topic. We construct a structural vector error-correction system to quantify the extent to which monetary autonomy has served to strengthen the real economy in Finland. This model is used to investigate directly the outcomes of Finland’s possible entry into the European Monetary Union. The outcomes indicate that monetary autonomy has played some role in insulating the real economy from the effects of shocks. Specifically, adjustments of the nominal exchange rate appear to have stabilized the real interest rate and, consequently, smoothed the changes in domestic demand. However, this role continues to be relatively small, and given the uncertainties involved, it’s possible that the impact has actually been negligible. Overall, we find no strong evidence to support a claim that monetary autonomy has served to stabilize significantly the Finnish economy…
Author: Tuomas Saarenheimo
Source: Research Discussion Papers, Bank of Finland
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