But in the context of the assessment of EMU membership, although the sustainable real exchange rate is still determined by fundamentals, the nominal sterling-euro exchange rate becomes a policy variable in the transition strategy.The shock of transition is the same as any demand shock. The difference is that policy choices, which make up the transition strategy, can potentially influence its nature and lessen damaging impact on transition costs. As entry to monetary union involves only fixing the nominal exchange rate, differences in inflation rates between countries will still enable relative prices, real exchange rates and competitiveness between countries to change inside a single currency area.From any starting point for the UK economy, the UK’s real exchange rate will eventually return to its sustainable equilibrium level, determined by the fundamentals of the real economy. The way the economy adjusts to reach this sustainable equilibrium would be different if the UK were to join EMU:Inside EMU, real exchange rate changes between the UK and euro area occur through changes in relative prices via national inflation rates.

If there were excess demand for UK production, there would be upward pressure on UK inflation and on the UK-euro area real exchange rate. UK products would be less competitive, encouraging switching of demand to euro area production. This process would continue until the initial excess demand had been eliminated.Outside EMU, the same eventual shift in relative prices would need to happen but the adjustment could also come through a change in the nominal exchange rate. Nominal exchange rates tend to adjust more rapidly than prices and are potentially less disruptive to growth and jobs in the adjustment phase.[Let us] assume a shock to the UK economy necessitated a permanent 10 per cent depreciation in the real exchange rate. Inside EMU, this would require UK prices to rise at a slower rate than in the rest of the euro area.

This adjustment could be protracted – with 0.5 per cent lower inflation over 20 years – or could be short and sharp, with 2 per cent lower inflation over five years. Either way, such an adjustment would mean years of output below trend, with knock-on effects of lower employment and higher unemployment; and outside EMU, a nominal exchange rate depreciation could help make the adjustment, lessening the impact on output and employment.The same adjustment mechanisms are at work in the specific case of the transition to EMU. If the sustainable real equilibrium exchange rate for UK entry into EMU is 10 per cent below the nominal level at entry, the transition phase could be associated with a period of imbalance for the economy, characterised by weak output growth and lower inflation in the UK than in the rest of the euro area.This would take either the form of a long period of gradual adjustment or a short, sharp adjustment. Similarly, if the entry rate were too low, in the same sense that it was below the sustainable rate, UK inflation would tend to be higher in the rest of the euro area for a period.Only the nominal sterling-euro exchange rate can be chosen on entry to EMU.