The shocking nature of output fluctuations in some EU countries

Recent literature on optimum currency areas has emphasized the importance of analysing the nature of the shocks facing the economy when deciding among alternative exchange rate regimes. In this paper we use a structural VAR to model the joint behaviour of real output, nominal interest rates, real interest rates and real money balances in response to four exogenous disturbances. Identifying restrictions are used so that these disturbances can be interpreted as supply, money supply, IS and money demand shocks. The analysis is performed on five major European countries. The principal objective is to investigate both the relative importance of these shocks in explaining the variance of output at different time horizons, and the dynamic response of these economies to each type of shock. Evidence presented in this paper indicates that the five economies under study have faced very different types of economic shocks over the recent past. The implication is that these countries are unlikely to meet the criteria for an optimum currency area. Unless a convincing case can be made that there are likely to be substantial economic benefits to offset this loss of a policy tool, there is a strong economic case for proceeding with monetary union with extreme caution.