Essays on Euro Area Enlargement

Marketta Henriksson’s dissertation examines issues related to the adoption of the euro by the new Central and Eastern European EU Member States.

The first essay studies the interaction between fiscal policy and the price level in different exchange rate regimes. The theoretical framework is based on the Fiscal Theory of the Price Level (FTPL). The results show that a credibly fixed exchange rate is inconsistent with fiscal irresponsibility, which implies that fiscal discipline is a prerequisite for successful participation in the exchange rate mechanism ERM II, while countries unable to commit to sound fiscal policies, probably should not commit to a fixed exchange rate either. Paradoxically, adoption of the common currency enables a country to conduct irresponsible policies, with the result that a rise in the debt level of one country raises the common price level of the monetary union.

In the second essay, a small open economy model is constructed, which allows the examination of the effects of Balassa-Samuelson-type growth – i.e. faster productivity growth in the traded goods sector than in the non-traded goods sector – in an intertemporal fixed exchange rate framework with a focus on the external balance, which has gained less attention in earlier research. The numerical simulations imply that the Balassa-Samuelson effect may increase the vulnerability of the economy. However, trade account deficits would appear to be a temporary phenomenon, as the deficits are decreased by the natural shift in the composition of consumption towards non-traded goods that is characteristic of catch-up.

The focus of the third essay is the effects of the EU fiscal policy rules on the fiscal variables, namely deficit and debt, and the external balance in the new Member States participating in ERM II. The numerical simulations show that a fiscal rule based on debt may be better at providing stability into the economy, while a deficit rule implies a smoother response to a transitory increase in output. External imbalances appear to be a natural part of the convergence process, which cannot be eliminated through the use of fiscal rules alone.