^*Philippe Karam is a senior economist with the IMF Institute; Douglas Laxton is assistant to the director of the IMF Research Department; David Rose is an IMF consultant; and Natalia Tamirisa is the deputy chief of the IMF Research Department's World Economic Studies Division. The authors thank Gian Maria Milesi-Ferretti for providing comments on an earlier version of this paper. We gratefully acknowledge the invaluable support of Michel Juillard, Heesun Kiem, and Susanna Mursula in developing the procedures used in the model simulations. Finally, we thank Yasmina Zinbi for her help in formatting the paper.

Abstract

This paper uses a two-country version of the global economy model to investigate some costs and benefits of a small, emerging economy's abandoning a flexible exchange rate regime in favor of adopting the currency of its main trading partner. The topic is particularly relevant for countries in central and eastern Europe, which recently joined the European Union and are now preparing to adopt the euro. We begin by evaluating macroeconomic performance in an inflation-targeting regime under various monetary policy rules. The results are then compared with the case where the small economy gives up its flexible exchange rate and joins the monetary union, under a number of alternative assumptions about the magnitude of shocks and structural rigidities. The analysis shows that although the monetary union has the benefit of eliminating exchange rate shocks, the loss of the buffering role of the exchange rate leads to greater volatility in domestic output and inflation. These costs are likely to decline over time, as markets become more competitive, flexible, and integrated in the monetary union.