Effects of European Monetary Integration on Unemployment: How Costly Was (Intra-European) Exchange Rate Variability?

Abstract

Eliminating intra-European exchange rate variability is often portrayed as one major advantage of EMU (reducing it was already a goal of the creation of the EMS in 1979). But why should politicians and economists care about exchange rate variability? Up to now the answer has usually been that exchange rate variability discourages trade. Unfortunately, a large empirical literature on this issue has not been able to document a strong link between exchange rate variability and the volume of trade. However, we would argue that the absence of a strong impact of exchange rate variability on the volume of trade does not imply that there should be no link between exchange rate variability and (un-) employment and investment. This becomes clear once one asks the question: why would an increase in exchange rate volatility lead quickly to a lower volume (flow) of trade? The theoretical models that are used in this context start typically from the idea that in order to export one needs to sustain a sunk cost. This sunk cost is meant to represent the need to build up a distribution system in foreign markets. But within Europe most firms already have a very elaborate distribution network in all member countries. A German automobile manufacturer will typically not have to build up a new distribution system in order to increase sales in other European countries. Hence we would argue that certainly for intra-European trade (the focus of our empirical work) market access costs cannot be the main reason why exchange rate volatility should affect trade.