DEPARTMENT OF ECONOMICS. Accession to the Euro-Area: A Stylized Analysis Using a NK Model. Bas van Aarle, Harry Garretsen & Cindy Moons

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1 DEPARTMENT OF ECONOMICS Accession o he Euro-Area: A Sylized Analysis Using a NK Model Bas van Aarle, Harry Garresen & Cindy Moons UNIVERSITY OF ANTWERP Faculy of Applied Economics Sadscampus Prinssraa 13, B.213 BE-2000 Anwerpen Tel. +32 (0) Fax +32 (0) hp://

2 FACULTY OF APPLIED ECONOMICS DEPARTMENT OF ECONOMICS Accession o he Euro-Area: A Sylized Analysis Using a NK Model Bas van Aarle, Harry Garresen & Cindy Moons RESEARCH PAPER JUNE 2007 Universiy of Anwerp, Ciy Campus, Prinssraa 13, B-2000 Anwerp, Belgium Research Adminisraion room B.213 phone: (32) fax: (32) joeri.nys@ua.ac.be The papers can be also found a our websie: (research > working papers) D/2007/1169/015 1

3 Accession o he Euro-Area: A Sylized Analysis Using a NK Model.* Bas van Aarle 1, Harry Garresen 2 and Cindy Moons 3 Absrac This paper analyses he accession o he Euro-Area by new members using a sylized new-keynesian model. We analyze macro-economic adjusmen in he pre- and pos accession case and calculae welfare in boh siuaions o obain ne benefi/loss from accession. I is shown how he effecs of accession is relaed o he conduc of moneary policy and fiscal policy in he pre- and pos accession case. The simulaion examples poin a he poenial coss ha accession migh enail due is consequences on moneary and fiscal policy design. These consequences from accession in erms of macro-economic sabilizaion abiliy of moneary and fiscal policies have no always been fully acknowledged and need aenion in our opinion. Keywords: Euro-area, Fiscal Policy, Moneary Policy JEL Code: F31, F41, G15 March Deparmen of Economics, Universiy of Maasrich, he Neherlands and research affiliae a CESifo, Munich, Germany. 2 Urech School of Economics, Urech Universiy, The Neherlands; Cenre for German Sudies (CDS), Universiy of Nijmegen, he Neherlands and research fellow a CESifo, Munich, Germany. 3 Universiy of Anwerp, Deparmen of Economics, Prinssraa 13, 2000 Anwerpen, Belgium. * We are graeful for commens received from paricipans of he CESifo conference Macro, Money and Inernaional Finance 2006 held in Munich, November 24,

4 1. Inroducion. On January 1h 2007, Slovenia -as he firs of he 10 counries ha enered he European Union (EU) on May 1h also enered he Euro Area (EA). Among many oher obligaions, he new members of he EU also commied hemselves o join he European Economic and Moneary Union (EMU) as soon as hey have fulfilled he enry condiions laid down in he Treay of Maasrich. The Maasrich Crieria (aricle 109 j (1)) provides convergence crieria in erms of inflaion, ineres raes, deb and deficis for he counries o qualify for enrance ino he EMU plus he requiremen ha a candidae counry should firs follow for 2 years he ERM II mechanism. Depending on he amoun of effor ha counries inves in complying wih hese enrance crieria here is a cerain degree of freedom in choosing he exac poin in ime o ener. In pracice, his means ha he period beween 2007 and 2012 seems he mos likely ime for heir EA accessions. 1 The righ iming for joining a moneary union is crucial and i is very unlikely ha a single sraegy could be recommended o all acceding counries regarding macroeconomic sabilizaion on he road o he euro. Argumens in favor of adoping he euro as early as possible include a smaller financial risk due o he eliminaion of conversion coss and exchange rae uncerainy, ineres rae convergence and overall gains in moneary credibiliy, while argumens for a slower pace o he euro include he need o remove firs disorions ha impede wage and price flexibiliy and he need o firs make fiscal and financial policy susainable and compaible wih paricipaion in he EMU. Auonomy in moneary and fiscal policy could sill be very useful in he shor and medium erm for he new Member Saes ha are in a process of gradual convergence o he EA and may sill be subjec o larger asymmeric shocks and adjusmens. During he recen years, moneary policy in he accession counries has indeed displayed a large variaion ranging from very sric euro pegging in he form of a currency board in small accession counries such as Esonia o informal euro arge zones in larger accession counries like Poland. Also he adjusmen of fiscal indicaors like governmen spending, ax revenues and budge defici display a marked variaion among he candidae EA counries. Apar from he iming and convergence scenarios, he accession o he EA raises several oher fundamenal quesions. E.g. wha are he consequences for he accession counries and is he accession beneficial for he acceding counries (and he curren EA members)? How does he accession of new members affec he moneary policy of he ECB? How does he accession affec he coordinaion of fiscal policies? Is here any effec of accession on he ineracion beween he EA and he res of he world? Such quesions are in many ways relaed o more fundamenal quesions on he degree o which he acceding counries consiue an opimal currency area (OCA) wih he curren EA. In fac, many of hese quesions concerning he accession of new counries o he EA are relaed and/or similar o quesions ha were raised during he consrucion of he curren EA. As concerning he OCA quesions, several sudies 1 Also for Bulgaria and Romania ha will ener he EU on January 1, 2007 enering he EA will become a relevan aspec in he medium o long erm. von Hagen and Traisaru (2005) and Backe (2004) review in large deail he curren exchange rae regimes, he performance of he new Member Saes wr he Maasrich crieria and he OCA aspecs 3

5 have analyzed he degree o which he accession counries may form an OCA wih he curren EA. In erms of rade inerdependence and business cycle convergence wih he E(M)U, he accession counries reach comparable scores like curren member counries (see e.g. Boone and Maurel (1999)). On he oher hand, he degree of symmery of shocks is generally found o be lower (see e.g. Fidrmuc and Korhonen (2003)). The laer finding may be problemaic in he sense ha he accession counries by acceding o he EA give up naional moneary policy independence and in paricular he possibiliy of exchange rae adjusmen vis-à-vis he EA in case hey experience asymmeric shocks. Upon accession, heir moneary policy will be se by he ECB. In addiion, he accession counries will adop he fiscal policy cooperaion and surveillance procedures of he Sabiliy and Growh Pac. Given he consideraions lised above i is, herefore, by no means clear under which condiions he accession is likely o occur. The loss of exchange rae and ineres rae flexibiliy is likely o enail negaive coss for he acceding counry, as does he possible increase in fiscal conservaism semming from SGP alike requiremens. Or pu alernaively, acceding o he EA as i implies a removal of moneary policy flexibiliy- may acually require an increase in fiscal flexibiliy raher han a reducion. On he oher hand, he change in he insiuional seings and micro-economic efficiency gains from a reducion of ransacion coss will benefi he accession counries. I is clear ha hese micro-economic efficiency gains from a common currency are hard o quanify. The Naional Bank of Poland (2004) e.g. assumes EA accession would conribue o a permanen 1.5% drop in real ineres raes and an associaed permanen increase of he real GDP growh rae of 0.2%. This paper sudies he effecs of accession of new members o he EA using a sylized New Keynesian macroeconomic model of an accession counry ha considers he accession o he EA. In our model, acceding he moneary union implies ha for he accession counry: (i) here are no longer exchange rae adjusmens possible vis-à-vis counries ha paricipae in he moneary union; (ii) is moneary policy is now se by he common cenral bank whose policy may no be opimal for he acceding counry because (a) i arges EA aggregae oupu and inflaion and (b) may have differen preferences; (iii) paricipaing in he moneary union could require ha fiscal flexibiliy is sronger resrained because of he necessary adopion of fiscal sringency measures like he Sabiliy and Growh Pac when a counry eners he moneary union. 2 Numerical simulaions of he model are used o analyze he effecs of accession o he moneary union and under which condiions such an accession is beneficial for he acceding counry. The correc way o measure and evaluae accession effecs (on macroeconomic adjusmen, policy formaion and cooperaion, and he relaing o heir accession. The convergence o EMU and he inended daes of accession are also considered. 2 In addiion here are a number of addiional effecs ha are ignored in his paper. These relae in paricular o changes in he area of policy coordinaion in he EA and decision making inside he ECB. Accession changes he sraegic seings and he possibiliies for cooperaion of policies for boh acceding and exising member saes. For he common cenral bank, he accession of addiional counries, implies ha: (i) here is a redefiniion of he aggregae arge variables; his by iself may already induce changes in opimal policymaking; (ii) is preferences may change if he acceding counries have differen preferences; his will affec policymaking; (iii) he sraegic configuraions (coaliion formaion process) in which he common cenral bank operaes have changed: he number of fiscal players in he moneary union increases and he number of ouside moneary and fiscal players decreases. The adjusmen dynamics from exchange rae adjusmen are changed. 4

6 resuling welfare losses) is by comparing idenical siuaions (in erms of shocks, srucures, and preferences) under wo scenarios: (i) wihou accession (or pre-accession) and (ii) wih accession (or pos-accession). The ne effecs can hen be solely aribued o he accession. We analyze macro-economic adjusmen in he preand pos accession case and calculae welfare in boh cases o obain ne benefi/loss from accession. The simulaion examples poin a he poenial coss ha accession migh enail due is consequences on moneary and fiscal policy design. Somewha ironically, hese coss increase he more efficien moneary and fiscal policy are in he pre-accession phase: counries ha are facing difficulies wih moneary policy commimen and fiscal defici bias, are likely o find ha accession helps ackling boh issues o a cerain exen. Counries ha have obained a high degree of moneary policy commimen and fiscal prudence, however, are likely o find heir sabilizaion abiliy largely decreased upon accession. A number of papers have sudied aspecs of EA accession ha are relevan for our sudy as well: Naalluci and Ravenna (2002) sudy he differen moneary and exchange rae sraegies in hese counries and he possible conflic beween he inflaion and exchange rae crierion due o presence of he Balassa- Samuelson effec. Bayoumi e al. (2005) calibrae a NOEM model of he EA accession counries o assess he saic and dynamic benefis of he fall in rading coss and higher level of rade inegraion from enering EMU, and he role of nominal and real rigidiies in he dynamics of his process. The analysis is opimisic on he poenial benefis from accession: in heir base case calibraion a 1 percenage poin reducion in rading coss (as a resul of accession) increases he rade of accession counries by 6 percen over he long erm, and raises he long-erm welfare of accession counries by he equivalen of abou one percen of consumpion. The main benefi comes from higher oupu and consumpion, alhough here is also some decrease in hours worked and hence an increase in leisure. Addiional benefis from accession come from financial inegraion and lower real ineres raes. Accession leads o boom including seady and large increases in rade, consumpion and welfare, and a boos o invesmen. This is financed by foreign borrowing which is repaid in he long-erm hrough a rade surplus. Ca Zorzi e al. (2005) develop a saic model of an accession counry. The benefis of a common currency are modeled as an increase in poenial oupu and confroned wih he losses from he disappearance of exchange rae flexibiliy. Devereux (2003) analyzes he effecs of EU enlargemen (inducing a capial inflow shock, an increase in rade flows and a fall in he exernal risk premium) under a fixed and a floaing exchange rae. The paper has been srucured as follows: Secion 2 proposes a sylized NK model. Secion 3 discusses he design of moneary policy in his model. Secion 4 discusses he simulaion resuls for various shocks. In Secion 5 some sensiiviy analysis of he oucomes w.r.. a few crucial model parameers is underaken. The conclusion summarizes our main resuls. 2. Effecs of Accession: A Sylized NK Model. Saring poin of he analysis is a counry ha is considering o accede o he euro-area. A crucial assumpion is ha he accession counry is small relaive o he EA. This small-counry assumpion implies ha i has 5

7 no influence on EA developmens and akes hem as being exogenous. Looking a he size, e.g. in erms of GDP, of he accession counries o he curren EA12 his assumpion appears realisic. In case he counry decides o ener he EA a some momen, he EA variables in he model sricly speaking need o be inerpreed as referring o he EA-excluding he accession counry. Given he small counry assumpion hese variables can be approximaed by he aggregae EA. The seup of he model is raher sandard and e.g. similar o Giordani (2001), Muscaelli e al. (2004), Svensson (2000), Leiemo e al. (2002) and ohers. The model is a sylized NK model in wo respecs: (a) while is srucure is broadly consisen wih he NK lieraure we do no aemp o work ou a fully specified underlying micro-economic srucure, (b) as a counerpar of (a), we do no aemp o esimae all model parameers for he EA accession counries ourselves bu insead use a se of plausible values. 2.1 The macroeconomic srucure The basic blocs of he model are he aggregae demand and aggregae supply curves, he Uncovered Ineres Pariy (UIP) condiion and he design of moneary and fiscal policies. Concerning he laer: we ry o include in he model a number of aspecs ha are relevan for acual moneary and fiscal policies in he conex of accession, in paricular he disincion beween moneary policy commimen versus discreion in he preaccession case and resricions on fiscal flexibiliy in he form of he Sabiliy and Growh Pac (SGP) in he pos-accession phase. The aggregae demand -IS curve-, of he candidae EA economy akes he following form: ( ) y = ψ y + (1 ψ) E y α i E p r + ηg + σy + δ( e + p p ) + u d (1) EA EA y denoes oupu produced in he accession counry 3, i he shor-erm nominal ineres rae, (he moneary policy insrumen), p he general price level, g he fiscal balance (a posiive value of g denoes a fiscal defici), e is he nominal exchange rae agains he Euro (a posiive value implying a depreciaion); r is he equilibrium real ineres rae. d u is an aggregae demand shock. All variables are given in logarihms and refer o deviaions from an iniial seady-sae. y EA and p EA denoe EA oupu and oupu prices, respecively. In his reduced form, oupu depends on pas oupu, expeced fuure oupu, he real ineres rae (expressed as a deviaion from he equilibrium real ineres rae), ne governmen spending, ne expors 4 and a demand shock. This IS curves ness several alernaive formulaions ha can be found in he lieraure: he curren oupu gap can be posiively relaed o pas oupu gaps only (Fuhrer and Moore (1995), Huh and Lansing (2000)), boh pas and expeced fuure oupu gaps, Clarida e al., (1999)), or expeced fuure oupu gaps only (McCallum (2001), Woodford (2001)). The backward-looking componen in he IS curve resuls from habi formaion in consumpion decisions 5. The forward-looking par is produced by raional, 3 Oupu and oupu gap in fac can be used inerchangeably as long as equilibrium oupu remains consan. 4 Ne expors are a funcion of foreign oupu and price compeiiveness: ne expors EA EA = σ y + δ( e + p p ). 5 Leih and Malley (2002), Baini e al. (2003) and McCallum and Nelson (1999) provide micro-foundaions for he presence of habi formaion in consumpion. Empirical evidence is provided ha he backward looking componen in 6

8 ineremporally maximizing agens ha apply he principles of opimal consumpion smoohing. In case consumers are enirely forward looking ( ψ = 0 ), (1) is also someimes referred o as he ineremporal IS. i Exchange raes adjuss in such a manner ha uncovered ineres rae pariy holds hroughou: where i EA denoes he EA ineres rae. E e = e + + i i (2) EA 1 Inflaion dynamics are given by hybrid Phillips-curves which conain elemens of boh forward and backward-looking price seing. In addiion, demand-pull and cos-push facors affec inflaion, s p = ω p + (1 ω) E p + γ( y y ) + τ ( p + e ) +u (3) EA Inflaion equals he firs difference of he general price level and is assumed o be a funcion of pas inflaion, expeced fuure inflaion, he oupu gap, y y, -reflecing demand pull inflaion- and inflaion of impor prices, EA ( p + e ) (he s.c. pass-hrough ), which induces cos-push inflaion. u, are domesic cos push shocks (or mark-up shocks) which will be inerpreed as supply-shocks in he remainder of he analysis since (3) can also be considered as describing he shor-run aggregae supply (AS) curve. In addiion, he supply side of he economy can be hi by shocks o poenial oupu viz. produciviy shocks y = y 1 + u. If ω = 1, we obain he backward-looking Phillips curve, if ω = 0, on he oher hand, we obain he forward-looking New-Keynesian Phillips curve 7. In he firs case, curren inflaion is srongly driven by pas inflaion (and economic condiions), creaing ineria in he adjusmen of inflaion. In he presence of forward-looking expecaions, curren price seing depends on expecaions abou fuure inflaion viz. economic condiions. The hybrid Phillips curve assumes ha boh backward and forward-looking price seing are presen, i resuls if ω lies in beween 0 and 1. The hybrid Phillips curve allows for boh a forward-looking componen and a backward-looking componen, reflecing e.g. learning effecs, saggered conracs or oher insiuional arrangemens ha affec pricing behavior. Demand shocks (u d ), cos-push shocks (u s ), poenial oupu shocks ( u ), fiscal shocks (u g ), EA oupu shocks (u yea ), EA price shocks (u pea ) and EA ineres rae shocks (u iea ) are all assumed o follow 6 s y y consumpion is subsanial. 6 See e.g. Gagnon and Ihrig (2002), Leiemo e al. (2002), Coenen and Wieland (2002) ha use similar open economy Phillips curves. 7 See e.g. Clarida e al. (1999) for a similar analyical framework and a deailed discussion on he generalised IS (1) and Phillips curves (2). They illusrae how ψ and ω joinly deermine he endogenous inflaion and oupu persisence. Leih and Malley (2002) derive (2) from he overlapping conracs model a la Calvo. In empirical applicaions, more lags of oupu (in case of he IS curve) and oupu and inflaion (Phillips curve) are ofen included o improve he empirical fi. Adding hese lags will also induce a more persisen and herefore more realisic adjusmen o shocks. In empirical sudies and moneary policy analysis someimes conceps of equilibrium and/or core inflaion are added o (2), o disinguish shor-run flucuaions of inflaion from longer erm, equilibrium inflaion. In our analysis his issue is no deal wih and inflaion (as all oher variables) is defined in erms of deviaions from (possibly non-zero inflaion) seady-sae. 7

9 saionary AR(1) processes u = ρ u 1 + v, wih 0 ρ < 1 and v is whie noise, v N σ v 2 (0, ), all shocks are assumed o be conemporaneously uncorrelaed, E vi v j = 0, i, j. 2.2 Moneary and Fiscal Policy Design and he Effecs of Accession Macroeconomic shocks lead o flucuaions in oupu and prices. The ransmission of shocks in he model, however, can be markedly differen in he pre- and pos-accession regimes due o he differences in he moneary and fiscal policy design. In he pre-accession regime, moneary policy auonomy implies ha ineres raes (and consequen changes in exchange raes) can be used he cenral bank o sabilize macroeconomic flucuaions, in paricular of inflaion and oupu. Fiscal policy is also assumed o be flexible in he pre-accession regime (or a leas no affeced from exernal consrains on fiscal flexibiliy such as he SGP). Upon accession, domesic moneary policy is replaced by a common moneary policy and possibly sronger resrains of fiscal flexibiliy. Following he erminology of Svensson (2000), he framework of moneary policy in he preaccession phase can be referred o as a seing of argeing rules. Targeing rules seek o deermine opimal policy responses o economic condiions, given a se of objecives. In he conex of he above model, we look a he policy sraegies ha minimize he following iner-emporal quadraic loss funcion: E τ = Γ β + τ + ξ + τ + τ + ν + τ + κ + τ = 0 ( ) 2 2 ( ) ( ) 2 ( ) L E [ p y y i e τ ] (4) subjec o he adjusmen dynamics of he economy, (1)-(3), (5) and under assumpions wheher or no he moneary policymaker acs under commimen or discreion. Sric inflaion argeing implies β > 0, ξ = ν = κ = 0, flexible inflaion argeing implies ha inflaion argeing is an imporan objecive of he CB bu ha i is also concerned abou oupu and ineres rae / exchange rae sabiliy, β > 0, ξ > 0, ν > 0, κ > 0 which seems o be he mos realisic case. Concerning moneary policy in he pre-accession phase we disinguish wo regimes, depending on wheher moneary auhoriies implemen moneary policy (i) assuming commimen or (ii) assuming discreion. In our dynamic NK model, he difference beween he commimen and discreionary case resuls from he forward-looking par of he model (he expecaions of he privae secor abou oupu, inflaion and exchange raes). Under (i) commimen he policymaker is able o opimally smooh he sabilizaion coss over ime: if a macroeconomic shock his he economy, he policymaker can announce a pah of curren and fuure policy acions and credibly implemen his sraegy. The privae secor ses is expecaions accordingly. Under (ii) discreion, such announcemens of fuure policy coningen on pas commimens are no credible. As a resul, under commimen adjusmens of ineres raes and inflaion will ypically display more gradual adjusmen and less volailiy han under discreion, given his abiliy o smooh ou he adjusmen coss over ime. Under discreion, policies and inflaion are excessively volaile in he shor run compared o he commimen case and also welfare losses will be higher wih discreionary policymaking 2 8

10 due o he exisence of such a sabilizaion bias in he shor-run 8. The differences beween commimen and discreion will vanish when oupu and inflaion expecaions become increasingly backward-looking 9, since in ha case he privae secor expecaions are less and less affeced by policy commimens, or saed differenly, opimal policies will suffer less and less from ime-inconsisency problems when expecaions become less and less forward-looking. In a purely backward-looking model, he ime-inconsisency problems of opimal moneary policy disappear by definiion. Concerning fiscal policy we assume ha ne governmen spending is deermined by a fiscal policy rule. Taylor (2000), developed a framework for simple fiscal policies ha relae ne governmen spending o he srucural fiscal balance, g, and he cyclical fiscal sance, as measured by he auomaic sabilizers χ y, he elasiciy of he defici o cyclical oupu flucuaions imes oupu. In addiion, we allow for he possibiliy of defici smoohing and he occurrence of sochasic defici shocks, u g : g = λgg + λg g χgy + 1 (1 ) ( ) g u (5) If χ > 0, fiscal policy conains a counercyclical componen ha provides auomaic sabilizaion of he business cycle flucuaions. The parameer λ (where 0 1) capures he degree of fiscal policy g λ g ineria/acivism: a high value of λ g would mean a very iner bu highly persisen- fiscal policy ha could be explained by difficulies o implemen changes in ax policies (e.g. pension reforms) and governmen spending (e.g. healhcare reforms). The fiscal policy rule (5) enables o represen in he model -albei in a highly sylized way- he various budgeary rules and sraegies one may observe in pracice. Here, we would like also o relae he fiscal policy rules wih he provisions in he Sabiliy and Growh Pac ha he accession counry faces in he pos-accession face. The budgeary arge g can be hough e.g. as being he close-o balance or in surplus medium erm objecive, reflecing a preference for long-run susainabiliy and neuraliy. The build-in flexibiliy in he Sabiliy Pac relies on allowing as much as possible he workings of he auomaic sabilizers in he shor-run. In a relaed manner, he amoun of ineria in fiscal policy, summarized by λ, reflecs he abiliy of fiscal policymakers o adjus fiscal policy in he shor-run. If λ g = 0 fiscal flexibiliy is he highes and he fiscal balance only driven by he auomaic sabilizers. If λ g increases, fiscal flexibiliy declines, implying more persisence in fiscal adjusmens. In he limiing case where λ g = 1, fiscal deficis do no adjus a all over ime. Ignoring fiscal shocks, his would imply he absence of fiscal sabilizaion. In our analysis we focus on a pre-accession phase ha is characerized by a combinaion of naional moneary policy auonomy and a significan amoun of fiscal flexibiliy. The accession he g 8 Discreionary policies will also induce an inflaionary bias in case he policymaker chooses an oupu objecive ha exceeds he poenial oupu, reflecing e.g he case of a dependen Cenral Bank ha is seered by poliical objecives. In he remainder of his sudy we will, however, no deal wih such cases. 9 Noe ha in our analysis, we will assume ha exchange rae expecaions are always se in an enirely forward-looking manner. 9

11 EA akes away he moneary policy auonomy, and possibly also fiscal flexibiliy. Taking away moneary policy auonomy implies he loss of nominal ineres raes and nominal exchange raes as adjusmen insrumens in he hands of he policymakers of he acceding counry. This is cosly in paricular if he auhoriies had achieved already a high degree of commimen and credibiliy. If hey lacked credibiliy before, he moneary ying of he hands of domesic policymakers (by enering a moneary union and giving up moneary policy auonomy) may acually be beneficial in iself, in ha i addresses he sabilizaion bias problem associaed wih discreion. If acceding he moneary union also requires ha fiscal flexibiliy is aken from he hands of domesic policymakers, here is addiional loss of sabilizaion ools. If fiscal managemen was generally adequae before he accession, his resricing of fiscal flexibiliy a he naional level may be counerproducive in he sense of conribuing o unnecessary volailiy and prolonged adjusmen afer macroeconomic shocks. If fiscal managemen was no adequae in he firs place, he accession may be conducive o disciplining also fiscal policymakers by imposing a resricive framework upon hem. In ha case a fiscal ying of he hands of he domesic policymakers may be beneficial o address a fiscal defici bias problem. I acs as an exernal fiscal commimen mechanism o underake unpopular defici-reducing measures. In general, he accession counries have made subsanial progress concerning credibiliy of moneary policy as winess convergence o low levels of inflaion and inflaion variabiliy -which do no differ dramaically from he ones observed in he EU-, increased Cenral Bank independence and ransparency of moneary policy. 10 As concerning fiscal policy here are considerably larger differences and fiscal sances range beween very pruden o excessively expansionary as some counries were faced wih subsanial fiscal shocks and difficulies in fiscal managemen. For accession counries wih fiscal imbalances, clearly he fiscal convergence requiremens from he Maasrich Treay are a major hurdle o ake and will ake away any room for acive fiscal managemen. 4. The Effecs of Accession: A Simulaion Analysis. This secion uses simulaions wih he model inroduced in Secion 3 o illusrae a number of insighs concerning EA accession. We simulae he effecs of demand shocks, cos-push shocks, poenial oupu shocks, fiscal shocks, and shocks o he EA variables in he model. All shocks are 1 percen in size, occur in period 0, are unanicipaed and have zero persisence. The assumpion of zero persisence of shocks enables o sricly disinguish he impac of shocks and heir subsequen propagaion. The simulaions of he shocks 10 See e.g. Dvorsky (2000) on CB independence in he counries in Cenral and Easern Europe. 10

12 provide (a) impulse response funcions ha give he dynamics adjusmens resuling from he shocks, including he ransmission of macroeconomic policies (b) variances and welfare losses resuling from sochasic simulaions of hese shocks (based on 100 replicaions), allowing us o invesigae ino more deail aspecs of efficiency. We compare he adjusmens under four scenarios. Two pre-accession scenarios feaure domesic moneary policy auonomy: (i) opimal moneary policy in case of policy discreion, (ii) opimal moneary policy in case of commimen. Two pos-accession scenarios which imply ha (iii) moneary policy is se exogenously by he ECB bu fiscal policy remains equally flexible as in he pre-accession case, (iv) moneary policy is se exogenously by he ECB and also fiscal disappears in he pos-accession case. In he simulaions we in paricular wan o obain insighs ino: (a) he effecs of accession relaing o moneary policy, (b) he effecs of accession relaing o fiscal policy. The firs effec is sudied by comparing oucomes under domesic moneary policy and under a moneary union, i.e. comparing case (i) and (ii) wih case (iii)). The second effec is analyzed by considering ha accession no only leads o he loss of moneary policy auonomy bu may in addiion also lead o a larger amoun of fiscal sringency, reflecing he workings of he SGP ha an acceding counry needs o comply wih upon accession o he EA, i.e. comparing case (iii) and (iv). Underlying all he simulaions in his secion is a se of baseline parameers provided in Table 1 ha characerizes in a sylized manner he srucure of he accession counry. The se of baseline parameers in he model concern: (i) he hybrid IS and Phillips curves: ψ, ω, (ii) oher reduced-form parameers of he NK model: α, η, σ, δ, γ, τ.: (iii) parameers ha characerize moneary and fiscal policy rules λ, φ, χ, µ, λ, χ, i i i i g g and moneary policy preference parameers Γ, β, ξνκ,,, (iii) assumpions on variances and auocorrelaions of shocks, i v ρ, σ. 2 i v [Inser Table 1 here] These parameers of he IS and Phillips curve and policy rules are se o values ha are broadly consisen wih empirical esimaes for he EA accession counries. 11 A number of empirical sudies sugges ha mos EA accession counries are characerized by a (i) subsanial degree of backward looking in oupu and inflaion, (ii) a subsanial degree of defici and ineres rae smoohing in he policy rules. In he absence of esimaes and also for he reason noed above we assume ha all shocks are uncorrelaed wih each oher and across ime ( v i 2 ρ = 0 ) and equal variances ( σ = 1 ). In he erminology of he radiional OCA heory i v his implies ha we concenrae on asymmeric shocks, i.e. when e.g. a domesic demand or supply shock 11 While he absence of any own empirical esimaions may seem a bi unsaisfying his ype of analysis based on calibraed parameers and/or parameers ha appears plausible from empirical sudies, is quie common in NK papers. See e.g. Jensen (2002) ha follows his line of hough and analysis and refers o compromise values when choosing parameer values ha would seem plausible for he U.S. case in his analysis. 11

13 occurs i is an asymmeric shock in he sense ha (he res of) he EA does no experience a similar shock. The OCA highlighs he imporance of naional policy auonomy and exchange rae adjusmen in such a seing of asymmeric shocks. Given ha he OCA heory focuses on asymmeric shocks, he assumpion abou he naure of shocks in our model seems adequae. Moreover, we do no only consider he radiional focus of he OCA on asymmeric demand and supply shocks ha hi a small open economy bu also consider a broader se of shocks, in paricular shocks in he EA. Given he high degree of inegraion beween he EA and he accession counries, his seems a useful exension. Moneary heory, namely, also prescribes he usefulness of exchange rae flexibiliy and domesic policy auonomy o ward off he effecs of foreign disurbances and conain spillover effecs on he domesic economy. Naurally, oucomes may be more or less specific o his se of baseline assumpions. In case of small changes in he parameers, he differences compared o he baseline are ypically of a quaniaive naure raher han a qualiaive naure. If changes ge larger, he resuls can also change qualiaively. In Secion 5 we will underake some sensiiviy analysis o ry o shed some ligh on ha aspec of he analysis. Simulaions of various shocks and heir ransmissions in he differen regimes allows o analyze and compare he macroeconomic adjusmen produced in he differen regimes. Sochasic simulaion analysis is used o sudy he effecs on he variabiliy of inflaion, oupu, ineres raes and exchange raes and o sudy welfare implicaions using he definiion of he loss funcion (4). In addiion, hree welfare indices are calculaed: (i) he sabilizaion bias I SB is a measure of welfare loss coming from discreionary policy making in he pre-accession phase, (ii) he opimal currency indices I OCA and II OCA are measures of he welfare gains/losses coming from he shif from a pre-accession regime wih domesic moneary policy o a posaccession regime wih a common currency, (iii) he fiscal flexibiliy index I FF calculaes he difference in losses in he pos-accession regimes wih (L MU ) and wihou fiscal flexibiliy (L SGP ). In oher words: SB L OCA L OCA L FF I =, I =, II =, I = L L L L L DIS MU MU SGP COM COM DIS MU A value of he OCA index smaller han one implies a ne gain from accession. 12 For he OCA index we make wo calculaions: one index (I OCA ) ha calculaes he welfare gains/losses from accession using he preaccession regime using naional opimal moneary policy under commimen as he benchmark and a second index (II OCA ) ha uses naional opimal moneary policy under discreion as he benchmark. Since moneary policy under commimen has always equal or less welfare losses han discreion, he ne welfare gain from accession is always lower in case of commimen in he pre-accession case. A value of he fiscal flexibiliy index larger han one implies an addiional loss afer acceding he EA caused by a sric inerpreaion of he SGP. (6) 1) A posiive demand shock 12 Noe ha we ignore he benefis from accession in he form of lower ransacion coss and oher micro-economic efficiency gains, if hese would amoun o some amoun % we could subrac ha amoun from he OCA index o ge he overall amoun of ne losses. Since we have no concree esimae of i is ignored in he analysis. Empirical sudies 12

14 Figure 2 displays he adjusmens ha are produced by a posiive one percen demand shock in he accession counry a = 0, (v d (0) = 1%). Oucomes under discreion (dashed lines), commimen (doed lines), moneary union (dashed-doed lines) and moneary union wih a sric Sabiliy and Growh Pac (doeddashed lines) are denoed wih suffix _DIS, _COM, _MU and _SGP, respecively. [Inser Figure 1 here] The demand shock increases oupu in he shor-run which ends o increase inflaion. In he pre-accession case, he Cenral Bank reacs by raising he ineres rae. This causes an iniial appreciaion afer which he exchange rae depreciaes according o he UIP condiion, in oher words exchange rae overshooing occurs. Ne expors are negaive due o he increase in oupu and he appreciaion. The increase of he real ineres rae, he real appreciaion and he fiscal surplus produced by he auomaic sabilizers conribue o he sabilizaion of oupu and inflaion. I is ineresing o noe ha he cyclical adjusmen dynamics are he resul of he combinaion/ineracion of boh forward-looking and backward-looking mechanisms in oupu and inflaion: boh a purely forward-looking and a purely backward-looking paramerizaion of he model would lead o a monoonic adjusmen from he same demand shock. In he pre-accession regime, he flexibiliy of nominal ineres raes and nominal exchange raes is a useful sabilizaion ool. This is clear from he smaller size of he flucuaions and more rapid adjusmens in he pre-accession cases. I is seen ha he moneary policy regime has an impac on he oucomes produced by he demand shock. Compared o discreion, commimen resuls in a more smooh adjusmen of he ineres rae and inflaion, reflecing he sabilizaion bias presen under discreion. Accession has a considerable impac upon he ransmission of he same demand shock: flucuaions of oupu, inflaion, fiscal deficis and ne expors are larger han in he pre-accession cases. An addiional aspec, is he greaer use of fiscal policy in he pos-accession regime han in he pre-accession case. Therefore, if in he pos-accession case also fiscal flexibiliy is aken away here are even larger oupu flucuaions and a more prolonged adjusmen pah (implying addiional welfare losses from accession). The differences in erms of losses beween oucomes in he differen regimes can be quanified more precisely using he oucomes from he sochasic simulaion found in Table 2. I provides for he various shocks and policy regimes, he variances of inflaion, oupu gap, ineres raes, exchange raes and fiscal defici plus he welfare losses and he welfare merics defined above. In case of demand shocks, he preaccession regime shows ha a subsanial gain resuls from commimen compared o discreion, as indicaed by he sabilizaion bias index of Commimen reduces in paricular inflaion variabiliy compared o discreion, conribuing o he lower losses under commimen. The pre-accession regimes score considerably beer han he pos-accession ones: he OCA indexes show ha here is a clear gain from keeping moneary sugges ha hese efficiency gains are ypically in he range of 1-5% of GDP. 13 Noe ha hese indices are dimensionless, hey do no provide informaion concerning e.g. he coss/benefis of accession in erms of foregone/increased GDP as is someimes ried in empirical sudies. 13

15 policy auonomy no only under commimen (OCA index of 2.83), even under discreion (OCA index of 1.24). Giving up fiscal flexibiliy in he pos-accession regime would lead o an addiional welfare loss since he fiscal flexibiliy index equals [Inser Table 2 here] 2) A posiive cos-push shock Nex, we analyse he effecs of a non-persisen one percen cos-push shock in Figure 2 (v s (0) = 1%): [Inser Figure 2 here] A cos-push shock ypically produces sagflaionary adjusmens: here is a subsanial decline in oupu and a burs in inflaion. As a resul of he iniial oupu fall, fiscal deficis and curren accoun surpluses resul. In he pre-accession case wih discreion, he ineres rae increases and he nominal exchange rae depreciaes. Commimen produces a considerably smooher sabilizaion of inflaion and oupu and less srong moneary policy inervenion han discreion. Lacking shor erm flexibiliy of he ineres rae and exchange rae (and fiscal flexibiliy in he SGP regime), he pos-accession regimes display sronger flucuaions of oupu and prices especially in a medium run. The resuling losses in Table 2 show again a considerable sabilizaion bias problem (he sabilizaion bias index has a value of 1.95). The OCA indices indicae ha in case of commimen a loss is obained from accession (I OCA = 17) in case of discreion, however, a significan gain resuls from accession (II OCA = 0.55). This is a clear illusraion of he general noion ha he effecs of accession depend very much on he moneary policy framework in he pre-accession regime and ha he more efficien moneary policy is se in he pre-accession, he smaller are he expeced benefis from accession. Fiscal flexibiliy in he pos-accession regime clearly maers given a value of 1.66 of he fiscal flexibiliy index. 3) A posiive fiscal shock The workings of a one ime expansionary fiscal shock (v g (0) = 1%) are quie similar o a demand shock as shown in Figure 3. [Inser Figure 3 here] One imporan difference comes from he fiscal rule iself: he iniial shock leads o a dynamic adjusmen process in he fiscal defici iself due o he defici smoohing mechanism. This is clearly seen in he adjusmen of he defici in Figure 4. The increase of oupu and appreciaion of he exchange rae lead o a curren accoun defici. Concerning variabiliy of oupu, inflaion and ineres rae and welfare losses we mosly reach he same conclusions as in case of he demand shocks. However, one aspec differs: given ha 14

16 he source of he macro-economic adjusmens is from he fiscal side, now in he pos-accession case, he regime wihou fiscal flexibiliy is conducive o macro-economic sabiliy as i limis he fiscal dynamics o a one-off shock. As a resul i scores beer han he accession wih fiscal flexibiliy regime (he fiscal flexibiliy index as a resul equals 0.49). This case relaes o he argumen noed in Secion 2.2 ha EA accession wih a reducion of fiscal flexibiliy could be beneficial for hose counries ha sruggle wih a fiscal defici bias in a pre-accession seing. Accession ha imposes an exernal consrain or commimen mechanism on domesic fiscal profligacy and defici bias. 4) A negaive shock o he EA ineres rae Shocks (1)-(3) were shocks of domesic origin. In line wih he radiional OCA heories which concenrae on adjusmen under asymmeric demand and supply shocks, our analysis quie srongly suppored he noion ha moneary policy auonomy (and also fiscal flexibiliy once in a moneary union) is desirable in he presence of domesic (or asymmeric) shocks. Pursuing his line of reasoning, one can also ask wha are he effecs of shocks originaing from foreign sources, such as foreign oupu, foreign price and foreign ineres rae shocks. Also hese shocks will coninue o hi he accession counry once i has moved from a preaccession o a pos-accession saus. I is herefore ineresing o consider in he model also he effecs of moneary and fiscal policy flexibiliy in he presence of foreign shocks. Figure 5 displays he effecs from a shock o EA oupu (v yea (0) = 1%). [Inser Figure 4 here] The effecs of he shock o EA ineres raes differ quie markedly beween he pre- and pos-accession regimes. In he pre-accession phase he exchange rae appreciaes insananeously which sabilizes mos of he impac of he shock: he effecs on oupu, inflaion and domesic ineres raes is limied compared o he pos-accession regime. Moneary policy commimen delivers again significan gains in sabilizing inflaion and oupu compared o discreionary moneary policy (I SB = 2.19). In he pos-accession case, he EA ineres rae decline implies also a same decline in he domesic ineres rae. This induces sronger and more cyclical flucuaions in oupu and inflaion han in he pre-accession case. This is also clear from he values of he OCA indices. The values of and 7.25 of I OCA and II OCA poin a a quie dramaic sabilizaion loss from accession. To make hings worse, upon accession fiscal flexibiliy is no providing much value added as suggess a fiscal flexibiliy index of 16. This example, in oher words, highlighs he noion ha no only domesic shocks are highly relevan when analyzing he effecs of accession bu also foreign shocks and spillovers need o be aken ino consideraion. In fac, in his case here are very srong differences in he preand pos accession, relaing o he differen adjusmen of exchange raes (or beer non-adjusmen in he pos-accession case) and ineres raes in boh regimes. 5) A posiive shock o EA oupu 15

17 Anoher shock ha deserves aenion is a shock o EA oupu. Wih a high degree of inegraion beween he accession counry and he EA, accession counries will be subjec o sronger spillover effecs hrough rade. Figure 6 shows he adjusmens produced by a 1% increase of EA oupu (v yea (0) = 1%). [Inser Figure 6 here] The direcion of he effecs are similar o hose produced by a demand shock bu he size of he effecs is considerably smaller given ha ne expors are only a fracion of oal demand. In addiion, he foreign oupu shock leads o a curren accoun surplus raher han a defici. Accession implies ha he spillovers increase as here are no longer adjusmens in exchange rae and ineres rae ha would parly offse he shock as in he pre-accession regime. This is clear from he increase in ineres rae and he (nominal and real) exchange rae appreciaion in he pre-accession case ha conribue o sabilizing he EA oupu shock. Taking ou fiscal flexibiliy in he pos-accession regime is furher aggravaing he macro-economic adjusmen problems for he acceding counries. The welfare indices highligh his aspec: I OCA, II OCA and I FF equal 2.83, 1.23 and 1.72, respecively (i.e. he same oucomes as under a demand shock). The resuls obained above were based on he specific se of baseline parameers ha was used and i may well be ha some values may be inaccurae. I is herefore ineresing and useful o check if he oucomes change if we change he baseline parameers. We experimened wih he following variaions relaive o he baseline se of parameers: (i) he degree of forward-looking in he IS and Phillips curves: ψ, ψ, ω, ω. Clearly, he amoun of forward-looking in he IS and Phillips curves plays a crucial role in he ransmission of shocks in he differen regimes and he effecs of accession. (ii) oher srucural parameers: α, η, σ, ζ, δ, γ, τ. (iii) parameers ha characerize fiscal policy rules λ, χ and moneary policy preference parameers Γ, β, ξνκ,,. We experimened wih alernaive fiscal policy rules o assess heir effecs. Boh in case of demand and cos-push shocks, a more iner and persisen fiscal policy increases he variance of inflaion and oupu. In case of demand shocks, less fiscal flexibiliy raises he variance of ineres rae, whereas he variance of ineres rae is lowered in case of cos-push shocks. This suggess ha from he perspecive of he moneary policymaker, fiscal flexibiliy is preferred in case of demand shocks, bu in case of cos-push shocks consrains on fiscal flexibiliy are needed. This oucome is robus across he hree moneary policy regimes. Nex, we varied he preferences of he ECB under commimen and discreion. (a) he variance of inflaion increases if he preferences for ineres rae smoohing increase and i decreases wih a higher preference for oupu sabiliy. (b) The variance of he oupu gap increases if ineres rae smoohing increases and i decreases wih preferences for higher oupu sabiliy. (c) Ineres rae variabiliy decreases wih higher preferences for ineres rae sabiliy and i increases wih higher preferences for oupu sabiliy. Moreover, hese effecs conclusions hold boh in case of commimen and discreion. (iv) assumpions on variances and auocorrelaions of shocks, σ 2 i i, ρ. The effecs of increasing or decreasing he variance of v g g 16

18 shocks are sraighforward: his will lead o proporional changes in he variances of inflaion, oupu ec. In addiion, in he baseline equal variances of all shocks were assumed and i was seen ha e.g. in erms of variabiliy of oupu, cos-push shocks imply he highes variabiliy of oupu and foreign oupu shocks he lowes. Increasing e.g. he variabiliy of foreign oupu shocks will, ceeris paribus, increases he relaive imporance of foreign oupu shocks -and decreases he relaive imporance of he oher ype of shocks- in explaining he variabiliy of oupu. Finally, he baseline se of parameers assumes ha all shocks are uncorrelaed wih each oher and are uncorrelaed over ime. The las assumpion was no only done because of absence of empirical esimaions bu also for exposiional reasons: increasing he degree of persisence of shocks has srong effecs on all adjusmens. The increased persisence of shocks will add o he inernal persisence of he model produced in paricular by he amoun of backward-looking in inflaion and oupu and he policy regime. In case of persisen shocks i will however no longer be impossible o disinguish how much of he persisence of variables is due o he persisence of shocks and how much of he persisence is inrinsic o he model Conclusions The enlargemen of he EA wih a new members, is receiving increasing aenion and ineres. Mos economic quesions relae direcly and indirecly o he radiional OCA heory. In his paper, we focused on he role of moneary and fiscal policy design in acceding o he EA, using a sylized NK model of EA accession. We compared oucomes in a pre-accession and a pos-accession regime o obain he effecs from accession o he EA by an accession counry. In he pre-accession regime we focused on he imporance of moneary policy being se in a conex of policy commimen or discreion, in he pos-accession regime we focused on he imporance of fiscal flexibiliy. While he original OCA heory focuses on demand and supply shocks, we add more ype of shocks o he analysis. In paricular, we also analyzed he consequences of shocks in he (res of) he EA on he accession counries. I was illusraed ha also hese shocks maer when considering he effecs of accession. The simulaion examples poin a he poenial coss ha accession migh enail due is consequences on moneary and fiscal policy design. These consequences from accession in erms of macro-economic sabilizaion abiliy of moneary and fiscal policies have no always been fully acknowledged and need aenion in our opinion. Somewha ironically, hese coss increase he more efficien moneary and fiscal policy are in he pre-accession phase: counries ha are facing difficulies wih moneary policy commimen and fiscal defici bias, are likely o find ha accession helps ackling boh issues o a cerain exen. Counries ha have obained a high degree of moneary policy commimen and fiscal prudence, however, may risk o find heir sabilizaion abiliy largely decreased upon accession. Exensions of he analysis could go ino several direcions: in paricular one could envisage o esimae he model for one of he accession counries. This would enable o obained more solid conclusions concerning he effecs of EA enlargemen in pracice. Anoher aspec ha could be considered concerns he 17

19 coordinaion of moneary and fiscal policy in he pre-accession phase and compare i wih he oucomes in he pos-accession phase. Inroducing coordinaion of moneary and fiscal policy in he pre-accession is likely o underline he poenial benefis from he unresriced policy design in he pre-accession phase and would herefore furher suppor raher han weaken our analysis. Appendix The model (1)-(4) can be wrien in sae-space form: X+ 1 X = A + Bi + Cv x x (A.1) EA d s EA EA EA where X = y 1 p 1 e 1 p 1 p 1 u y u y p i i 1 g p is a 14*1 vecor of predeermined variables in he model, x = [ y p e a 3*1 vecor of forward-looking variables, i = [ i ] a 1*1 vecor of ] insrumens and v = v v v v v v v a 7*1 vecor of macroeconomic shocks. d y s yea pea iea g where Y The objecive funcion of he policymaker (6) can be rewrien as; y y π 1 E τ = Γ + τ + τ τ = 0 min L E Y ' WY s.. (A.1) (A.2) i = = D + i i 1 x e e X β ξ 0 0 Ci i is a 4*1 vecor of arge variables and W =, he marix 0 0 ν κ wih weighs of he differen objecives. The model (A.1)-(A.2) is a sandard linear sochasic regulaor problem wih raional expecaions and forward-looking variables Opimal policies can be deermined (a) under a regime of policy commimen, (b) under policy discreion (see e.g. Oudiz and Sachs (1985), Backus and Driffill (1986), and Söderlind (1999), Jensen (2002) for he deailed working ou of he opima; policies under commimen and discreion cases). 18