Exchange Rate Regimes for the New Member States of the European Union

One important issue for the new Member States (NMS) of the EU is the choice of the exchange rate regime that will allow them to participate successfully in the EMU process. Two exchange rate arrangements, compatible with the EU Treaty and ERM2 regulations, deserve special attention: flexible exchange rate regime and currency board with respect to the euro. The first regime (within stipulated bands), coupled with an inflation targeting scheme, agrees with the spirit of the European Commission and absorbs more easily supply shocks and Balassa Samuelson effects (which are present in real convergence and catching up episodes). It also prompts the process of nominal convergence. The second regime is suited to countries that need to foster the credibility of their monetary policy, but makes real adjustments to country-specific shocks and Balassa-Samuelson effects more difficult and/or costly. In this paper we investigate the dynamics of output and inflation under each exchange rate regime in NMS during the post EU accession and Maastricht phases. For that purpose, our model extends Gerlach and Smets (2000) and Detken and Gaspar (2003), icluding market distortions and three possible exchange rate regimes. In the empirical part of the paper we estimate SVAR models, following Bayoumi and Eichengreen (1993) methodology, in order to extract variances and covariances between shocks to each NMS and to the euro zone and compute individual social losses under each exchange rate arrangement. We use monthly data on industrial production and CPI for eight NMS countries. Our main result is that the optimal choice varies depending on the institutional and structural features of each economy, and on the likely source and nature of economic shocks to which it is exposed with respect to the whole euro area. Interestingly, the results for each country seem to conform to the general prescriptions that one would derive from the theory of optimal currency areas