Research Discussion Papers, Bank of Finland
Monetary Policy for Smoothing Real Fluctuations? – Assessing Finnish Monetary Autonomy
Abstract: The possible participation of Finland in the Stage III of
the European Monetary Union would constitute a major 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 increase the severity of business
cycles in Finland? This is the question the present paper seeks to analyze.
In the first part of this paper, we review and evaluate the existing
econometric work on the consequences of the European Monetary Union.
Although the empirical work on the subject is abundant, it suffers from a
narrow focus. Most of the research follow a highly simplistic empirical
implementation of the traditional Keynesian theory of optimal currency
areas and measure the desirability of a currency union by cross-country
correlations of certain macroeconomic variables. We find the results
obtained in those studies hard to interpret, and argue that – particularly
when measured in a mixed exchange-rate system as has prevailed in Europe –
simple macroeconomic correlations do not convey any meaningful information
about the desirability of a currency union.
In the second part we
present an alternative approach to 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 stabilize the real economy
in Finland. This model is applied to analyze directly the consequences of
Finland's possible entry into the European Monetary Union.
suggest that monetary autonomy has played some role in insulating the real
economy from the effects of shocks. In particular, 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
has been relatively small, and given the uncertainties involved, it is
possible that the effect 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.
Keywords: EMU; optimal currency area; Finland; structural VAR models; (follow links to similar papers)
39 pages, May 14, 1996
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