Real Exchange Rates Within and Between Currency Areas: How Far Away is EMU?

Abstract

The renewed quest for a European monetary union raises the question: Is Europe ready for a common currency? We compare the conditional variance and the persistence of real exchange rate shocks within the German monetary union and between Germany and eight European countries to assess the viability of a monetary union in Europe. The results suggest a 'Europe of Two Speeds': A core union among Germany, her smaller neighbors and France would be viable today. Further reduction of real exchange rate variability is needed, in contrast, between these countries and Denmark, Italy, and the United Kingdom. Alternatively, monetary union should be postponed until further adjustment has occurred. Such a waiting period would neither require nor benefit much from further tightening of the current EMS. Copyright 1994 by MIT Press.