MONETARY UNION, CENTRAL AND EASTERN EUROPE.

This paper aims at clarifying the interactions between the choice of the exchange rate regime prior to the ERM-2 as well as various modes of ERM-2 itself, on the ease of fulfilling the Maastricht criteria, explores the mechanics of the exchange rate regime switches as applicable to the New Member States (NMS), and discusses the weak vs strong parity arguments faced by the new EMU applicants. New Member States with pegged exchange rates should have lower debt and deficit levels, but higher inflation than the floating or managed floating counterparts, and that was indeed the case in the 2003-2005 period. Fixed exchange rate does not fully solve the problem of final parity speculations. However, especially the countries with euro-linked currency boards are likely to avoid bond yields pick-up, and higher fiscal costs, related to the risk of the final parity being set at a weaker level than that prevailing during the pre-ERM-2 peg period. What is more, the mechanics of the target zone literature suggests that an unlikely switch from the fixed exchange rates into the target zone with weaker parity may still lead to nominal appreciation. While no fundamental exchange rate modelling is attempted in this work, two main views regarding the choice of the ERM-II parity level. Thanks to high productivity growth, the NMS so far are in a relatively comfortable position allowing to compensate for a relatively strong exchange rate which could be needed to ensure low enough inflation prior to the EMU entry