European monetary union and the outsiders

Abstract

This article looks at the impact on a small outside country if a larger, outsider country were to join a nearby monetary union, exemplified by the likely effects on Norway of the UK deciding to join the Euro. We construct a theoretical model to capture such effects, which focuses on the effect of union on Norway as the small outside state. We then estimate the model using data from the period 1980–1999 (the period covering the existence of the ECU and the Euro), and find that there would be substantial implications for the management of the Norwegian economy in response to asymmetric shocks and EU fiscal and monetary policy.

¹ This article forms part of research on the regional implications of EMU on UK and Norway, organised within Europa-programmet's ‘Storbritannia-prosjekt’ on ‘Britain, Scandinavia and the EMU’.

Acknowledgement

I. D. McAvinchey wishes to acknowledge the generous support of a Leverhulme Trust Emeritus Fellowship in this research.

Notes

¹ This article forms part of research on the regional implications of EMU on UK and Norway, organised within Europa-programmet's ‘Storbritannia-prosjekt’ on ‘Britain, Scandinavia and the EMU’.

² We assume that and (that is, the income and interest elasticities of money demand are identical). It could be argued that relaxing the first pair of assumptions would improve the generality of the model, whilst retaining the quality of the results, but it would do so at the cost of reducing the elegance by which the model are presented, and needlessly obfuscate the key results.

³ Assuming purchasing power parity, that is, the real exchange rate is equal to unity. The real exchange rate normally would reflect long run productivity differences between the union countries and the nonmember country. In practice, they may exist for a whole host of reasons, for example due to imperfect competition in the labour market, barriers to the free movement of goods (including transport costs), and differences in consumer tastes. In this model we assume no such long run differences persist. Such supply side considerations are beyond the scope of analysis of this model.

⁴ We assume that , and (that is, the marginal propensities to consume union goods in union countries are identical and equal to the marginal propensity to consume nonunion goods in the nonunion country, the marginal propensities to import are identical in all countries, and the marginal propensities to consume union goods in nonunion countries are identical to those for consuming nonunion goods in union countries). Once again, an argument could be made that relaxing these assumptions would improve the generality of the model. However, the assumptions are minor in importance and they do considerably enhance the elegance by which the model is presented, without altering the key results. The substitution involves the elimination of the real interest rate from the system, assuming that the real interest rates are constant across the union and nonunion countries, that is, (R ^EU − Π^EU) = (R ^UK − Π^UK) = (R ^N − Π^N) and the real interest elasticities of investment are equal in the long run.