Toward the European Monetary Union - A Need for Exchange Rate Flexibility?

We address the question of the exchange rate regime for the Czech Republic before it enters the EU and the EMU. We classify the macroeconomic impacts of a single currency regime according to the traditional OCA theory. Using quantitative measures, we find the degree of macroeconomic convergence between the Czech and German (EU) economies high enough not to form a major obstacle to a fixed currency regime. In addition, we look at the transitional specificities of the Czech economy. We analyze the real appreciation of the Czech currency and its relationship to competitiveness and find that the development of cost factors exercises downward pressures on the exchange rate. Conversely, a fixed regime may alleviate the problem of foreign capital inflows and the ensuing nominal appreciation - another idiosyncrasy of the Czech economy. However, once labor market rigidities are removed, a fixed regime may become the source of a sustainable competitive advantage, growth, and convergence.