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Macroeconomic consequences of the adoption of the euro: the case of Slovenia.

Article Excerpt
Introduction

1 January 2007, Slovenia started to replace its currency, the Slovene tolar, by the common European currency euro. Slovenia was the first of the ten states joining the European Union (EU) in May 2004 to enter the Euro Area (cf. Hochreiter and Sitz 2004). All of the new EU member countries have been members of the European Economic and Monetary Union (EMU) from the beginning of their membership in the EU, albeit with a derogation. Being EMU members does not imply that these countries may introduce the euro immediately. Before adopting the common currency, the new EU member states are required to fulfill the criteria set out in the Maastricht Treaty. In May 2006, the European Commission and the European Central Bank decided that Slovenia had fulfilled all relevant criteria.

The adoption of the euro can be expected to exert non-negligible effects on the Slovene economy. To a large degree, positive effects of economic integration, in particular regarding intensifying trade relations, have already materialized with the successive reductions of trade barriers during the EU accession negotiations and upon EU accession in 2004. Nevertheless, the introduction of the common currency may have implications going beyond facilitating international trade. Both benefits and costs of this change in the institutional structure of the Slovene economy are to be expected.

This paper aims at estimating the macroeconomic consequences, that is, the costs and benefits from adopting the euro on the Slovene economy. To do so, simulations with SLOPOL6, a macroeconometric model of the Slovene economy, are performed. The macroeconomic costs and benefits of Euro Area accession are evaluated by contrasting model simulations with flexible and fixed exchange rates on the one hand and by estimating the impact of the euro adoption on total factor productivity (TFP) on the other.

The paper is structured as follows. In the next section, the effects of Slovenia's Euro Area membership are discussed theoretically. Next, the SLOPOL6 model used for the simulations is briefly described. In the following Section, the size of the macroeconomic effects of adopting the euro is estimated by means of simulations of the SLOPOL6 model. Finally, the main findings are summarized and conclusions are drawn.

Effects of Adopting the Euro: Theoretical Considerations

The accession to the Euro Area will bring about benefits, but costs also have to be considered. In this section, some potential costs and benefits arising from adopting the euro are discussed theoretically. The costs of replacing the domestic currency with the euro are associated with abandoning an independent monetary policy. In the Euro System, monetary policy is conducted by the European System of Central Banks and the European Central Bank (ECB) in particular. Therefore, monetary policy and thus the exchange rate can no longer be used for internal stabilization purposes in the member countries. Especially during the transition process with rapidly growing productivity and real appreciation of the domestic currency, nominal exchange rate flexibility may be important. Furthermore, as long as the business cycle is only loosely correlated to the development of the current Euro Area countries, monetary policy can be an important instrument for coping with idiosyncratic shocks hitting the economy.

These considerations are rooted in the optimum currency area (OCA) theory. According to the OCA theory, a common currency is beneficial for countries with similar business cycles and a high degree of openness towards the movement of production factors (Mundell 1961). In the case of Slovenia, these criteria are only partially fulfilled. While almost all barriers to international trade and factor movements were removed upon EU accession, business cycles have not been totally synchronized. However, this should not be a severe problem as more recent contributions to the OCA theory show that the OCA criteria are not static but endogenous (Frenkel and Rose 1998; Fidrmuc 2004). Moreover, Slovenia (like most other new EU members from 2004) has largely adjusted its economic policy to prepare for membership of the Euro Area (Breuss et al. 2004).

The expected benefits from adopting the euro are numerous. Most importantly, transaction costs associated with exchanging foreign currencies and hedging against exchange rate risks are eliminated. For a small country like Slovenia, with just two million inhabitants and a high degree of openness, this effect is...