The Euro Area and the World Economy

• Author: John Green and Phillip L. Swagel
• Position: Deputy Division Chief in the World Economic Studies Division of the IMF's Research Department/Economist in the World Economic Studies Division of the IMF's Research Department

European monetary union will bring both new opportunities and fresh challenges for economic policies in countries outside the euro area.

The advent of European Economic and Monetary Union (EMU) and the development of a single, more powerful economic market will have an impact both on the other economies of Western Europe and on other countries with established trade and financial links to Europe, including countries that will link their own currencies to the euro. The transition economies of Central and Eastern Europe and the Baltics, the developing countries of the Mediterranean basin, and countries in Africa are most likely to be affected by EMU. Countries in Asia and the Western Hemisphere and advanced economies outside Europe will also be affected, though to a lesser extent.

Global environment

The global environment has been supportive, until now, of the transition to a single currency for 11 members of the European Union and the achievement of their economic objectives.

[ SEE THE GRAPHIC AT THE ATTACHED RTF ]

Strong demand by advanced countries for exports from the euro area, coupled with the depreciation of the currencies of euro area countries over the past three years, has stimulated recovery in the euro area and helped to offset the effects of the Asian crisis (see chart). As the growth in demand from these areas is likely to slow, however, it will become more important for demand within Europe to become self-sustaining.

There are also challenges for EMU in the global economic environment.

* The crisis in Asia and other emerging market economies could produce adverse spillover effects on the euro area and make monetary policy more difficult to carry out.

* If the crisis deepens further, external demand could weaken and dampen the current recovery in Europe, which, in turn, could dampen confidence and domestic demand.

* In addition to the portfolio shifts expected as investors become accustomed to holding the euro, financial market volatility could add to uncertainty in assessing the economic indicators that the European Central Bank (ECB) will be monitoring.

* The weakness of the yen over the past several years and the recent volatility in the yen-dollar exchange rate demonstrate how rapidly market exchange rates can deviate from those indicated by medium-term fundamentals; such deviations could adversely influence financial conditions and monetary policy deliberations in the euro area.

* The Asian crisis, coupled with the possibility of a broader crisis in emerging markets, could influence the transmission of policy to the real economy if, for example, commercial banks in the euro area have to make substantial provisions for nonperforming loans.

The euro

While the future behavior of the euro cannot be readily predicted, it is likely to appreciate against the dollar and the pound sterling over the next few years, but to depreciate against the yen. Exchange rate movements along these lines may have already begun. Cyclical factors-the United Kingdom and the United States are at more...