From transition to monetary integration: Central and Eastern Europe on its way to the euro comments on the country papers (1).
Monetary policy and monetary integration issues are currently debated intensely in most current and prospective EU accession countries. The four papers included in this section provide a very good picture of this discussion. In fact, they are important and highly pertinent contributions to the ongoing debate.
At the same time, the four papers offer a striking illustration of the varieties of factors related to Monetary Union and the diversity of perspectives and aspects considered important in different countries. For example, where Borowski bases his argument on the overall macroeconomic cost-benefit story, Vujcic stresses the financial market dimension. These differences are, of course, justified given the variety of starting points and the varying weights policymakers in different countries have given to these policy problems.
On the other hand, the effects of monetary integration will impact these countries with varying degrees of intensity. This creates two problems, perhaps more from a political than an economic point of view, that may be important as the process of integration proceeds.
(i) The first problem is the gap between existing expectations and future developments. If the integration runs smoothly and there are no additional disturbances, monetary integration should generate positive benefits, but it will not solve all the problems. The requirement to satisfy pre-specified criteria to participate in monetary union can serve as a powerful policy instrument to address a wide number of policy issues. But flexibility must be maintained. In both the medium and long term, the programme to join the Monetary Union should not be treated as a 'deus ex machina'. To do so may lead to a dangerous underestimation of policy needs and create a large gap between expectations and the reality of Monetary Union, which may lead to disappointment and a weaker commitment from the population.
Borowski provides a good example of this problem, the important benefit of creating/joining a Monetary Union comes from the 'dynamic effects' on investment and growth (Baldwin, 1992). Unfortunately, these large effects are uncertain and depend on how a country creates opportunities. Empirical estimates of these effects vary widely and are sometimes close to zero. Presently, we understand little about the size of the long-term net benefits, or how long it will take for these benefits to materialise. (2) Care should therefore be exercised in advertising that there will be sizable benefits from Monetary Union, as the potential benefits are not automatic and will take time and effort to develop.
(ii) The second problem is implicit in the fact that these countries have given different weights to the economic problems they face. It is a strong indication that the risk of asymmetric shocks may be much more pronounced than usually expected. Under these conditions, much more effort and flexibility will be needed to adjust economic structures. Care must be taken in analysing the differences between countries and in drawing general conclusions from this about the integration process.
A useful approach to further explore monetary policy and monetary integration of current and prospective EU accession countries is to ask where is the common ground in the discussion on these matters and what are the open issues.
It is generally agreed that the endpoint of the monetary integration process is the adoption of the euro, upon having achieved a high degree of sustainable convergence. In economic terms, there is widespread agreement that the long-term net benefits of future participation in the single currency area should be positive, given that the new member states are small open economies, and the EU is the focal point in terms of trade and financial integration.
The institutional framework that will govern the monetary integration of current and future acceding countries was agreed in the accession negotiations, based on EU Treaty provisions, and is described well in the four papers. Previous convergence assessments, in conjunction with Ecofin reports on the exchange rate aspects of enlargement, provide guidance on the practical application of the convergence criteria that have to be met for the adoption of the euro. As pointed out in several other contributions to this volume, for countries entering the EU in May 2004 the earliest possible date for joining the euro area presumably is January 2007. This follows from the required minimum stay of 2 years in ERM II without severe tensions, which is a pre-condition for a positive convergence assessment.
This raises a key question about the appropriate timing of the individual stages of monetary integration after EU accession and the design of policies along the way. To answer this general question, one must address two more specific issues. First, what is the appropriate time span, in economic and political economy terms, for individual acceding countries to fulfil the Maastricht convergence criteria? Second, when will individual acceding countries be able to give up the monetary and exchange rate policy instrument at reasonable cost?
Fulfilling the Maastricht criteria
How do acceding countries perform with respect to the Maastricht convergence criteria and what is a reasonable time horizon for meeting these benchmarks? Frequently, this question is approached by comparing the current progress of acceding countries with the experience of the South European euro area countries 5 years before their entry into the monetary union (eg Csermely does this for Hungary). The main conclusion drawn from such comparisons typically is that acceding countries are currently as well placed to fulfil the convergence criteria in time for an entry into the euro area in 2007 as the South European Member States had been 5 years before they adopted the single currency. Such comparisons show that, in general, acceding countries have made substantial headway towards nominal convergence. At the same time, the reduction of substantial fiscal imbalances in a number of Central European countries is a substantial challenge, especially for the Czech Republic, Hungary, Poland and Slovakia. Also, while overall inflation developments are largely benign (even if one takes into account that temporary factors have spurred the disinflation process recently), the reduction of inflation to low Maastricht-compliant levels will require further stabilisation efforts in several acceding countries, particularly Hungary, Slovakia and Slovenia.
While such comparisons are instructive, one should not overlook their limitations. Government budget figures of acceding countries are not yet completely in line with ESA95 standards and full compliance may yield higher deficits than suggested by the figures released so far. (3) The key problem areas are the classification of various public entities, the treatment of government support to firms and banking sector restructuring costs, accruals-based calculations and the recording of some specific central bank payments into the budget.
While the size of the required adjustments may be similar to those in South European countries during the last decade, spending pressures are more pronounced in acceding countries, mostly due to the additional spending on EU accession that is projected over the next few years. Also, the windfall gains from interest rate convergence will be lower than in the South European countries. Furthermore, fiscal positions in a number of Central European acceding countries have worsened in recent years and the implementation record of medium-term fiscal strategies is weak. Moreover, fiscal slippages are mainly due to structural rather than cyclical factors. Taking all these factors together, it appears that fiscal challenges in acceding countries are more pronounced than the present figures would suggest.
Temporary output and employment losses associated with fiscal consolidation in high-deficit countries are often perceived as the main short-term costs to euro area entry. This, in turn, has raised questions about the optimal time path of fiscal consolidation. The empirical evidence on expansionary fiscal contractions (see eg Giavazzi and Pagano, 1990, 1996; Alesina and Ardagna, 1998) suggests that fiscal adjustments tend to be successful, lasting and not harmful to short-term growth (perhaps even expansionary) if they are expenditure based, especially if the spending cuts are in social transfers and the government wage bill. Large adjustments are more likely to be successful and lasting than small ones, although the composition of the adjustment itself seems to be more important. There is also some evidence that adjustments tend to be more successful if they are accompanied by agreements on wage moderation and/or currency devaluation.
What does this imply about the prospects for a swift and sustained correction of budget imbalances in acceding countries that currently have recorded high deficits? Judging from their medium-term fiscal strategies, the general approach is to tackle deficits through expenditure cuts, which is in line with the recommendations made in the literature. On the other hand, acceding countries may find it difficult to achieve substantial cuts in these areas. Acceding countries typically have a comparatively low public sector wage bill. Moreover, the share of the wage bill in total expenditures may actually increase because the current wages of public servants are low and the administrative capacity needs improvement to ensure implementation and enforcement of the European Union's acquis communautaire.
The levels of social and welfare expenditures vary considerably across acceding countries. They range from 11 to 27% of GDP, being much larger in Central Europe than in Baltic countries. Against the backdrop of consolidation needs, and high levels of social and welfare spending, reductions in social and welfare expenditures will be needed. Backe et al. (2002) argue that this should primarily be done by keeping real growth of social and welfare expenditures below real GDP growth. The current low-inflation environment should make it easier to resist pressures for (quasi-)automatic indexation. Restraining social expenditures eventually depends on a society's preferences regarding the size of the welfare state. There appears to be a strong desire, in particular, in Central European countries, for a strong welfare state. This cannot be entirely disregarded when designing a sustainable fiscal consolidation strategy.
The prospects for a sustained correction of budget imbalances without negative effects on economic dynamics are mixed in acceding countries presently recording high fiscal deficits. While the general approach to tackle deficits through expenditure cuts bodes well, specific conditions in accession countries make the prospects for cuts in the public sector wage bill and social transfers less likely. In the Central European setting, fiscal consolidations may therefore lead temporarily to lower growth and higher employment. If this is so, strong and sustained political determination will be required to implement a strategy aiming at fast entry into the euro area. In a less supportive setting, a more gradual approach may be more appropriate. In this context, it is worth mentioning that EU fiscal rules allow, under certain conditions, for a gradual correction of excessive fiscal deficits, that is, deficits above 3 % of GDP. EU rules will therefore allow acceding countries with high budget deficits to adopt a fiscal strategy that reduces budget deficits below 3 % of GDP over a medium-term horizon, provided there is a sufficiently ambitious and credible adjustment programme in place.
One can therefore conclude that some acceding countries may be in a position to meet the Maastricht criteria soon after EU accession, namely those that currently have low budget deficits and are committed to contain fiscal imbalances in the future.
Renouncing monetary independence irrevocably
The second key question regarding optimal timing of monetary integration is when an acceding country should give up monetary and exchange rate instruments. Misalignment, post-euro adoption, can lock a country into a below-potential growth path for an extended time if comparative price and wage levels are out of line and adjustment does not occur with sufficient speed.
At the same time, output volatility is high in catching-up economies. In real convergence settings, therefore, it appears particularly important to assess the output volatility implications of different policy frameworks and opt for arrangements that contain such variability.
There are a number of theoretical arguments as to why high output volatility may have negative effects on long-term growth. These arguments relate to skill losses (Martin and Rogers, 1995), increased political uncertainty (Alesina et al., 1992), credit-market imperfections (Stiglitz, 1992) and the postponement of investment decisions in times of uncertainty (Dixit and Pindyck, 1994). The empirical literature tends to validate these theoretical propositions (see Ramey and Ramey, 1994; Martin and Rogers, 2000; on welfare effects see Gali et al., 2002).
The standard approach starts with the traditional OCA framework and explores how much the acceding countries have converged to the euro area in terms of economic structures and business cycles and how far their trade and financial integration with the euro area has advanced. In the same spirit, adjustment mechanisms in the product and factor markets function are also examined (see respective sections in Csermely).
How do the acceding countries fare with respect to the main OCA indicators? In a nutshell, one may say that most acceding countries score well in the areas of openness, trade and financial integration. The same also holds largely for economic structures, at least at broad sectoral levels (with some qualifications for agricultural employment shares in several countries). The record on cyclical synchrony is mixed, as Fidrmuc and Korhonen (in this volume) show. Suppel (2003a) and Horvath (2001) present a similarly heterogeneous picture. Relative country performances deviate somewhat between these studies, with the exception of Hungary, which shows a high degree of synchronisation in all three papers. Likewise, the evidence is mixed in the area of labour and product markets.
While differences in GDP per capita levels are not per se an obstacle to participation in a monetary union, the fact that acceding countries have embarked on a catching-up trajectory still raises some issues with respect to the timing of the monetary integration process.
A country that records high trend growth rates will presumably experience very low or perhaps even negative real interest rates post-euro adoption.
This would imply overheating and boom-bust cycle risks. Such risks can be mitigated if there are other policy instruments to cope with stabilisation challenges. In particular, the question is whether appropriate fiscal policy reactions would be feasible to contain aggregate demand pressures. Given the fiscal picture in acceding countries and the competing demands on fiscal resources, one may question whether there would be sufficient scope for tightening in all countries under review here.
The evidence so far is varied. Some acceding countries have coped well with stabilisation issues in a low real interest rate setting for a prolonged period. Others have relied on comparatively high real interest rates, and it is an open issue how these countries would cope with much lower real interest rates in a monetary union. In addition, future trend growth levels as well as the sensitivity of aggregate demand to real interest changes may differ among acceding countries. Consequently, this issue may be highly relevant for some acceding countries, while it may have no bearing on the optimal timing of monetary integration for others.
A second issue, already touched upon, relates to the implications of monetary integration for output volatility. Does a flexible nominal exchange rate help smooth output variability or does it add to this variability?
There is some evidence for the larger acceding countries that exchange rate flexibility has helped stabilisation. Suppel (2003a) investigates this issue by using a bivariate VAR model that describes the inter-temporal relations between the real exchange rate and industrial output growth. He finds evidence, based on Granger causality tests, that the real exchange rate has adjusted to variations in growth in these countries, while there is much less evidence for reverse causality. Real exchange rate flexibility, promoted by nominal exchange rate flexibility, has therefore tended to act as a buffer in these countries and has thus helped smooth output variability. Furthermore, the results show that shock absorption is more efficient under a flexible exchange rate regime than under an inflexible one.
While the evidence at this stage is limited, it underscores that it can be a viable and--with a particular view on stabilisation issues--potentially beneficial option for countries that operate a flexible exchange rate regime to retain such a regime over the medium (and perhaps even longer) term. At the same time, a flexible exchange rate regime is not a reasonable option for all acceding countries, as it presupposes the existence of sufficiently liquid financial markets. Moreover, it is not an attractive proposition for countries that have well-functioning and credible fixed exchange rate regimes in place.
Finally, a question arises for countries that operate an exchange rate peg or will move to such a regime in the future. Should a country with a peg hold on to the exchange rate as an adjustment instrument of last resort to react to severe adverse shocks (ie as an escape option in a period of substantial distress)? This depends on how one assesses future misalignment risks for a given country and whether adjustment mechanisms other than the nominal exchange rate will be sufficiently well functioning to bring about adjustment at reasonable costs. Wage shocks that may be difficult to correct post-euro adoption could lock a country into an under-performance trap for some time. A nominal exchange rate change may be distinctly useful in facilitating the adjustment in such a situation, if the underlying problem in wage formation is tackled at the same time. Whether this problem is sufficiently important to tip the balance in favour of slower monetary integration in any of the countries remains to be seen.
Implications for intermediate stages of monetary integration
If a new Member State does not opt for a fast-track approach to the euro, questions will arise about the timing and the duration of ERM II participation. The answer will mostly depend on a country's monetary and exchange rate strategy and how well such a strategy has served the country so far. This is particularly true for inflation targeting frameworks with a flexible exchange rate. In addition, the interaction of exchange rate commitments and other policy areas, especially fiscal policy, will also play a role.
If a country opts for staying in ERM II for more than the minimum period of 2 years (before the convergence assessment), it may use the full flexibility of the mechanism at this initial stage, before moving on to the testing phase associated with the exchange rate criterion. This may be an attractive proposition for countries that enter ERM II from a wide band or a managed float exchange rate framework and still want to retain a tangible degree of monetary independence under a multilateral exchange rate framework.
SPECIFIC ISSUES RAISED IN THE INDIVIDUAL COUNTRY PAPERS
Apart from these general issues, the individual papers raise a number of specific issues. It would go beyond the scope of this paper to address all the relevant issues that are addressed in the four papers so the treatment here is highly selective.
Ross and Lattemae raise the issue of meeting of inflation criterion in fast-growing countries with a tightly fixed exchange rate regime. This is a relevant point and deserves consideration.
First, catching-up economies experience a trend appreciation of the real exchange rate. Thus, it is not possible for these countries to achieve a stable price level and full nominal exchange rate stability simultaneously over a longer time horizon. The Maastricht criteria take this into account, as they provide for some flexibility both with respect to price stability and to exchange rate stability. In fact, 'the assessment of exchange rate stability against the euro will focus on the exchange rate being close to the central rate while also taking into account factors that may have led to an appreciation, in line with what was done in the past' (Ecofin, 2003). Currency board arrangements preclude taking advantage of the leeway the exchange rate criterion provides. Still, countries that operate such frameworks still can rely on the degree of flexibility the inflation criterion offers. This criterion states that inflation can exceed the average inflation in the three best-performing EU countries by no more than 1.5 percentage points. If inflation in these three countries were substantially lower than inflation in the euro area, this would lead to a low reference value. Such a situation would be a matter to be addressed in the application of the criteria but not a reason to alter the criteria.
It should also be noted that higher growth need not be associated with higher inflation. On the supply side, for example, the presence and the magnitude of the Balassa-Samuelson effect depends on higher sectoral productivity growth differentials than prevailing in the anchor country and on equal wage growth trends across sectors. If growth is driven by similar productivity increases in tradable and nontradable sectors or if there is differential wage growth across sectors due to some labour market segmentation, the Balassa-Samuelson effect is not or only partially effective. This simple illustration suggests that the underlying sources of price dynamics are the core of the issue. In pragmatic terms, one has to be assured that these underlying factors are of a benign nature and do not point to an unsound inflation bias.
A second point relates to the analysis of the yield curve in order to extract information about market expectations on the timing of euro adoption in individual acceding countries. Csermely has an intriguing analysis focusing on the convergence of forward yields. While such analyses provide useful illustrations, they also have their limitations. For one, they hinge on a set of assumptions, as Csermely points out rightfully. Furthermore and perhaps more fundamentally, it is not a straightforward matter whether the information one can extract from yield curves indicates expectations about the prospective participation of that country in the euro area or the future convergence path of a country. Suppel (2003b) explores the case of the Czech Republic showing that forward yields in this country have fallen to German levels and that the co-movements of Czech and German yields have increased over time. However, the correlation of bond yields has increased mainly for spot (5-year) yields rather than for comparable forward yields (5-year maturity 5 years forward). Thus, while there is evidence that market perception of nominal and real convergence has increased, there is no clear evidence that the markets already consistently price in a euro area entry by the Czech Republic.
A third interesting subject discussed in the papers is the implication a high degree of de facto euroisation has for monetary policy and monetary integration. Vujcic depicts lucidly the limitations that such a setting imposes on macroeconomic and especially on monetary and exchange rate policies. While a high degree of de facto euroisation does not necessarily complicate a programme for successful disinflation, as the case of Croatia shows well, it entails some specific financial stability risks. Vujcic rightly stresses the systemic solvency risks that arise if the local currency depreciated sharply. In addition, there are also liquidity risks, as the lender of last resort role of the central bank is constrained if the financial system is characterised by a high degree of foreign exchange-based financial intermediation. Tight prudential regulation can reduce these risks but at the cost of impeding financial intermediation (in the extreme case, it may come close to 'financial repression'). While the adoption of the euro will eventually do away with these problems, it should not be seen as an instrument to achieve this objective. Rather, the challenge for highly 'euroised' countries is to design and implement a comprehensive set of policies that reduce the risk of using local currency and enhance the attractiveness of local currency-based financial intermediation, thereby lessening the incentives to use foreign currencies in domestic transactions.
THE AUSTRIAN EXPERIENCE--SOMETHING TO LEARN FROM HISTORY?
In general, one has to be very cautious in drawing conclusions from the experience of one country in giving advice to another country. Nonetheless, Austria's experience in joining the EU and the Monetary Union provides some useful cautions for accession countries.
Austria's economic history--long before thinking about joining the EU and Monetary Union--was characterised by a very strict peg of the Austrian schilling to the German mark. This policy developed after the breakdown of the Bretton-Woods system because of a widespread feeling that freely floating exchange rates would have negative effects on long-term expectations and, therefore, negative consequences on investment and employment. Over time, this DEM peg came close to a monetary union of the Austrian economy with Germany (of course, without introducing banknotes and coins), which in the end led to a situation where ERM entry did not matter at all and did not change any policy. (4)
But it was clear right from the introduction of this policy that there were a number of crucial preconditions for making it a success: high export and import shares with Germany; a 'social compromise' to accept this kind of 'integration' and its consequences; and the acceptance and overall suitability of German macro policies as well as the willingness to deliver the 'absorbing flexibility' needed to adjust to this framework in economic policy terms whenever needed.
On a more theoretical level, the so-called 'Scandinavian Model of Inflation' (Mooslechner, 2002) and the overall acceptance of incomes policy as one of the important policy instruments contributed to the concept. Based on this line of economic policy thinking, it was accepted by all important social groups at the time that the adjustment burden had to be put on the real sector and its structural flexibility. This was facilitated by favourable productivity developments in the Austrian economy, driven mainly by (imported) technical progress, innovation and a re-orientation in the sectoral specialisation of the Austrian economy.
What were the important framework conditions for this specific kind of policy orientation? The implicit objectives held important were mainly threefold: (i) low inflation, (ii) exchange rate stability (to stabilise expectations and thereby investment and exports) and (iii) competitiveness (seen as a major factor in the determination of employment under the conditions of a small open economy). The specific role of incomes policy developed mainly from the recognition that it would be very difficult or almost impossible to address all these economic policy goals at the same time by macroeconomic strategies alone. Incomes policy was based on a social compromise concerning income distribution. A simple, productivity-oriented wage policy element was added to the macropolicy framework. This was done in a coordinated and centralised manner, taking into account macroeconomic needs whenever necessary (Hofer and Pichelmann, 1999).
Despite a high degree of 'institutional stability', this specific mix of policies created a labour market characterised by a high degree of macroeconomic real wage flexibility. Until today, collective wage agreements make explicit reference to past and projected productivity growth and inflation as well as to the state of the labour market and the business cycle. Therefore, it can also be expected that macroeconomic real wage flexibility can be sustained in the context of Monetary Union.
But what really counted in the end was a high degree of credibility that macroeconomic policy would be adjusted whenever needed. Sometimes, substantial deviations from the anchor country were accepted by the markets because there was an overall belief that economic policy would be used to correct these deviations over the medium term. In fact, it was perceived 'controllability' that was seen as the main factor to make this policy approach successful.
Despite having a fixed peg to the German mark for about 20 years and having created a specific kind of incomes policy to keep inflation under control and to strengthen competitiveness, Austria's accession to the EU in 1995 had a considerable impact on the Austrian economy (Breuss, 1992, 1996). There were price pressures at both the wholesale and consumer levels. The trade balance deteriorated and a marked increase in perceived competition was felt in several sectors, including the retail sector and agriculture.
Thus, even after a very long period of adjusting the Austrian economy to the European market and to the German economy in particular, joining the EU created further pressures for structural and policy adjustment. To a smaller extent--and somewhat hidden behind the policy measures to fulfil the Maastricht criteria--the same effect occurred after the start of Monetary Union once again.
If one were willing to draw--very tentative--conclusions from the Austrian experience, they would tend to indicate that even after a very long and successful adjustment process--and even if there were no questions that an economy had adjusted to the 'right' central parity for its exchange rate-integration would come as a shock, putting clear pressure on a country's ability to adapt structures and policies in line with the new situation. This suggests that the adjustment needs that result from integration and the related challenges for policy making should be duly taken into account when discussing the timing and the overall preparedness to proceed with further integration steps.
For accession countries, this appears to underline the importance of creating a robust policy framework that delivers macroeconomic adjustment and corrects deviations, combined with a microeconomic setting that provides for flexibility, be it through a combination of functioning markets and neo-corporatist elements, as for example in Austria, or through well-functioning markets alone.
(1) The views expressed in the paper are those of the authors and do not represent the position of the Oesterreichische Nationalbank or the European Central Bank.
(2) This is particularly true for the effects of a common currency on trade and growth, which is a highly contested issue. There is considerable debate about the magnitude of these effects in the case of the EMU. An in-depth discussion of this issue is beyond the scope of these comments. For a review of the main contributions to this debate, kicked off by Rose (2000), see Skudelny (2003). On the other hand, the magnitude of the static and dynamic benefits from transaction cost savings is clearer but relatively moderate.
(3) The following analysis on fiscal issues draws on Backe (2002), Backe et al. (2002) and Backe and Wojcik (2004).
(4) Austria joined the ERM in January 1995, a few days after acceding to the EU. The strict DEM peg continued without any change, and the [+ or -] 15% standard fluctuation band was solely used against other participating currencies, in tandem with the DEM movements against these currencies.
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PETER BACKE (1) & PETER MOOSLECHNER (2)
(1) European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany. E-mail: email@example.com;
(2) 0esterreichische Nationalbank, P.O. Box 61, 1011 Vienna, Austria. E-mail: firstname.lastname@example.org
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|Author:||Backe, Peter; Mooslechner, Peter|
|Publication:||Comparative Economic Studies|
|Date:||Mar 1, 2004|
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