Monetary policy for smoothing real fluctuations? Assessing Finnish monetary autonomy

The possible participation of Finland in the Stage m of the European Monetary Union would constitute a major change in the operating environment of the Finnish economy.As a member of the common currency area, Finnish interest and exchange rates would no longer be determined by domestic monetary policy or domestic financial market reactions, but would instead be given by the European Central Bank and the European financial markets.Would this increase the severity of business cycles in Finland?This is the question the present paper seeks to analyze. In the first part of this paper, we review and evaluate the existing econometric work on the consequences of the European Monetary Union.Although the empirical work on the subject is abundant, it suffers from a narrow focus.Most of the research follow a highly simplistic empirical implementation of the traditional Keynesian theory of optimal currency areas and measure the desirability of a currency union is by cross-country correlations of certain macroeconomic variables.We find the results obtained in those studies hard to interpret, and argue that - particularly when measured in a mixed exchange-rate system as has prevailed in Europe - simple macroeconomic correlations do not convey any meaningful information about the desirability of a currency union. In the second part we present an alternative approach to the empirical analysis of the topic.We construct a structural vector error-correction system to quantify the extent to which monetary autonomy has served to stabilize the real economy in Finland.This model is applied to analyze directly the consequences of Finland's possible entry into the European Monetary Union. The results suggest that monetary autonomy has played some role in insulating the real economy from the effects of shocks.In particular, adjustments of the nominal exchange rate appear to have stabilized the real interest rate and, consequently, smoothed the changes in domestic demand.However, this role has been relatively small, and given the uncertainties involved, it is possible that the effect has actually been negligible.Overall, we find no strong evidence to support a claim that monetary autonomy has served to stabilize significantly the Finnish economy.