This paper reviews the economic debate surrounding both the opportunities and the challenges arising from European monetary union. It is organised in two parts. Part I examines the economic environment in EMU, analysing the role of markets and the macro-economic framework. It finds that the prospect of EMU has already succeeded in creating a stable macro-economic environment, but that structural reforms aimed at better functioning markets take more time to be implemented and to produce results. Part II investigates the issue of adjustment in EMU in response to macro-economic disturbances, exploring the potential contribution of market mechanisms and macro-economic policies for coping with country-specific shocks. It finds that the new macro-economic framework will soon enable automatic stabilisers to operate better than in the recent past, but that it may take longer for market mechanisms to play their full part.II/0452/97-ENEconomic Policy in EMU. Part B. Specific Topics. (ECONOMIC PAPERS. No. 125. November 1997. European Commission. Brussels. 187 p. Tabl. Graph. Bibliogr. Free.)This paper explores a number of policy issues deriving from Economic and Monetary Union: - Monetary Policy and the Exchange Rate; - Budgetary Policy; - Shocks and Market Adjustment; - Real and Nominal Convergence. II/0453/97-ENOn January 1st 1999, Economic and Monetary Union (EMU) will move to its third and final stage. The exchange rates between the parties will be locked irrevocably and the euro will be introduced. The responsibility for monetary policy in the participating countries will be entrusted to the newly-created European Central Bank. European monetary union must be understood as comprising two separate, but complementary facets: a single currency, and a stable currency. These two facets correspond to the two interrelated objectives of EMU: efficiency and stability. The commitment by national public authorities to meet the terms of the Treaty on European Union for creating EMU is already bearing important fruit in terms of stability: in the past several years, the convergence towards low inflation has been spectacular and, although more efforts are in order, budget deficits have been substantially reduced. This has resulted in more stable nominal exchange rates and lower long term interest rates, thus paving the way to the current economic recovery. Although EMU represents first and foremost a monetary reform, its implications are much wider. The construction of EMU is geared towards the stability of the new currency, and sound public finances. Together with a well-functioning Single Market, this new policy regime is bound to bring about a new economic environment with fundamental consequences for the behaviour of public and private agents. The gradual elimination of budget deficits, as provided for by the Stability and Growth Pact, implies that government debt, currently still at too high levels, will be set on a consistently downward path. This will have beneficial consequences for interest rates and private investment, help restructuring public expenditure by giving more weight to growth-enhancing factors (such as investment in education and infrastructure), and raise the room for manoeuvre of national budgetary policies in stabilising the cycle. Budgetary discipline will also imply a new, fairer contract between the current and the next generation which will not have to shoulder the burden of today's spending choices. In total, with the change brought about by the EMU regime, the risk of a new stability conflict between the monetary and budgetary policies, which in the past repeatedly contributed to the unsatisfactory growth and employment performance of the Community, could be avoided in the coming years. Private agents, as consumers and producers, will not only benefit from lower transaction costs and simplification entailed by the replacement of multiple national currencies by the euro, but will also see their spectrum of choice broadened. The euro will strengthen the effects of the Single Market due to higher price transparency and greater competition. The relationship between factors of production will also undergo important changes. It will become apparent that if prices and wages are inconsistent with macroeconomic stability and with the Single Market rules, there will not be a “bail out†by public authorities - be it in the form of budgetary handout, looser monetary policy or “defensive†industrial policies. To the extent that wage and price behaviour anticipate this constraint, EMU will lead to a greater efficiency and higher employment. The changes in behaviour on the part of public authorities and private agents in the new EMU regime are desirable per se, as a means of tackling the structural problems faced by Europe, namely the high and structural unemployment and the budgetary consequences of ageing. Hence EMU acts as a catalyst of changes which would have to take place anyhow to shift the European economies on a path of sustainable growth and high employment. By definition, EMU implies the loss of national monetary autonomy. One of the criticisms often levied against the EMU project is that member countries will not be able to respond to economic disturbances via changes in national monetary policy or in their nominal exchange rate. It is then alleged that negative shocks will result in a surge of unemployment. In reality, the exchange rate, being a “national†instrument - in that it changes the whole set of domestic prices vis-à-vis third countries - is potentially appropriate only in a narrow set of circumstances, namely in the event of shocks affecting the entire national economy and only that economy. If the shock only effects a particular region or sector, a devaluation would lead to over-heating in other parts of the economy. Mutatis mutandis, the same can be said of monetary policy. Shocks that are truly national are already relatively infrequent. And they will become even more so once EMU is in place: The stability-oriented macroeconomic framework will reduce the likelihood of policy-induced shocks (such as disturbances originating in reckless fiscal behaviour), which in the past have been an important source of country-specific shocks. Moreover, the increasing trade interdependence among EMU members will further blur the economic importance of national boundaries, thereby reducing national specificity of economic developments. Admittedly, in those circumstances in which a change in the exchange rate or national monetary policy would have been useful, alternative adjustment channels will have to be provided for in EMU. At the macroeconomic level, a rapid reduction of deficits below the 3% threshold will create sufficient room for automatic fiscal stabilisers to offset cyclical downturns. Where structural adjustment, rather than mere macro-economic stabilisation is called for, changes in prices and wages will be needed. This requires that product and labour markets operate with greater flexibility. In conclusion, EMU offers important opportunities for better allocation of resources, higher growth and higher employment, but also challenges of completing the necessary budgetary consolidation and stepping up the reforms in product and labour markets. Meeting these challenges will ensure not only the full success of EMU, but will also help in solving Europe's structural problems.