The euro as an institutionally diverse monetary union

Abstract

We analyse the causes and consequences of the adoption of a common currency by countries with persistently different institutional quality, as in the euro area. A diverse monetary union has redistributive effects on investment and fiscal capacity across countries and societal groups. A common currency leads to rapid market adjustments while nominal wages lag, and institutional differences persist, resulting in hidden currency revaluations and devaluations. Productive and fiscal capacity benefit in core countries with stronger institutions, while public spending is less constrained in periphery countries with weaker institutions just as their fiscal capacity is reduced by revaluation. Firms and employment gain in core countries, along with savers in periphery countries.