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The impact and desirability of the European Monetary Union is the object of much debate among economists and policy makers. The abandonment of flexible exchange rates along with monetary policy autonomy has potential benefits that can only be realized at the cost of imposing limits on country specific stabilization policy. The magnitude of these costs and benefits depend on the relative strengths of alternative transmission mechanisms for both real and monetary shocks throughout the euro zone. Eijffinger and de Haan (2000, p.147), summarizing the debate, argue that qualitatively, these channels differ widely among countries.

National structures differ within Europe because of differences in consumption patterns and production specialization. Financial structures also differ widely across countries some countries have well developed and relatively efficient stock markets and financial institutions, while other countries rely heavily on information intensive or collateral based lending reflected in their national banking systems. Given this diversity across product markets and financial markets, it seems likely that exogenous shocks will have different impacts in the various member states composing the euro zone. In the presence of such heterogeneity, one needs to carefully consider whether or not a common currency amplifies or dampens the destabilizing influences of real and monetary shocks.

Recent studies have raised the issue of transmission channels through the distribution of credit, stressing the importance of financial frictions. Europe’s financial system is segmented and heterogeneous. Lending institutions and their associated loan rates are country-specific. Borrower balance sheets are also heavily influenced by local market conditions and regionally determined asset valuations. In this environment, cross-country differences in borrowing costs are not well arbitraged. As a result, exogenous shocks will have different effects in the various member states composing the euro zone, making the loss associated with multiple monetary instruments possibly more severe. Such considerations must serve as a counterweight when assessing the gains to monetary union.

In this paper, we consider the influence of financial factors in the gains and losses associated with adopting a montary union. We find that the importance of financial frictions, the degree of financial heterogeneity and the extent of financial integration across countries have important implications for the monetary transmission mechansim, but that the currency regime itself does not necessarily modify the impact of shocks for a given structural financial system. Methodologically this implies that the precise characteristics of the financial environment must be taken into account when assesing the benefits of stabilization policy in a monetary union.

Among our results, three specific findings stand out. First, in the absence of heterogeneity across financial systems, the influence of destabilizing financial factors in response to country specific shocks is relatively insensitive to the monetary regime monetary union vs multiple currencies. Because the financial acclerator has important cross-country spill-overs, it acts as a coordinating device which increases cross-country co-movement and reduces international disparties. This lowers the benefits to multiple currencies. Second, by providing additional financial coordination, financial integration further reduces the benefit to multiple currencies relative to a monetary union. With heterogeneous financial systems, there are some potential gains to multiple currencies, even in response to common shocks, if both countries are willing to adopt strong anti inflationary stances. These gains appear to be small however, suggesting that the heterogenous effects of financial frictions do not provide a strong motive for multiple currencies over a monetary union.

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