Lessons from the European Monetary System

Federal Reserve Bank of Cleveland August 15, 1987 exchange-rate considerations. Because been compromised by exchange-rate many facets of policymaking and imple- of Germany's economic importance volatility of nonparticipating currencies mentation. The slow progress of the ISSN 0428·127 within the European Community, the vis-a-vis the ERM currencies. European community with respect to the other participant countries have had to In particular, the Deutsche mark tends ERM and policy coordination, however, adjust their domestic policies or their to appreciate against other European exemplifies the difficulties of achieving exchange rates to remain competitive in currencies when the dollar depreciates. 9 agreements on these many points. Im- international markets under the con- The January 1987 realignment in the plementing target zones on a wider scale ECONOMIC Lessons from the straint of German monetary policy. ERM, for example, was necessitated in would be all the more difficult. Differ- Nations participating in the ERM large part because the dollar's deprecia- ences in preferences, policy objectives, European Monetary arrangement often buy and sell foreign tion against the Deutsche mark caused and economic structures account in part System currencies to defend their exchange the mark to appreciate relative to the for these difficulties. rates. Unfortunately, when such inter- other currencies in the ERM. Such re- More fundamentally, however, coor- by Nicholas V. Karamouzis vention is not supported by a change in a COMMENTARY alignments become necessary because dination of macroeconomic policies will nation's monetary policy, nor coordi- international investors do not hold all not necessarily benefit all participant nated with the intervention activities of ERM currencies in equal proportions in countries equally, and those that benefit other central banks, it only has a limited their portfolios and because of economic the most may not be willing to compen- influence on exchange rates. 8 and financial differences among the sate those that benefit least. In the Many economists and policy makers towards those of the best performer, exchange-market intervention. The Very The heavy intervention preceding the ERM countries. ERM, Germany is less inflation-prone have argued that the industrialized coun- West Germany. J Short -Term financing facility provides January 12, 1987 realignment, for ex- To deal with this phenomenon, the than the other ERM countries and is tries could minimize exchange-rate vola- This Economic Commentary dis- an unlimited amount of very short-term ample, was mostly intramarginal and ERM countries need a common policy reluctant to cooperate at the risk of in- tility and enhance economic stability if cusses the exchange-rate mechanism of credit to finance intervention at the com- generally was not accompanied by response to external disturbances in creasing its inflation rate. 10 West Germany, Japan, and the United the European Monetary System. The pulsory intervention margins. The Mo- changes in nations' monetary policies. general and to the dollar in particular. Similarly, if benefits to the United States linked their currencies in a target- first three sections describe the opera- bilization Mechanism permits Germany, in particular, made only small For example, an upward adjustment of States from coordination of macroeco- zone arrangement. tion of the ERM. The final section high- temporary exchanges of official ECUs adjustments to monetary policy in re- interest rates by the ERM countries, nomic policies with the other industrial Under a target-zone system, countries lights some problems facing the ERM for currencies, mainly to finance intra- sponse to the exchange-rate pressures. except Germany, could have helped countries are small, the United States adjust their national economic policies that are germane to the operation of any marginal intervention, or intervention to Consequently, the intervention failed to divert part of the capital flows that may be reluctant to relinquish its policy to maintain their exchange rates within a target-zone system. influence exchange rates within the per- contain speculation , and a realignment moved into Deutsche marks into other independence, which is a necessary specific margin around agreed-upon, missible bands. The Short-Term Mone- became unavoidable. ERM currencies. condition for an effective coordination fixed central exchange rates. I Such a tary Support provides credits based on a There are other problems. If a target of policies and for the maintenance of system already exists for the major Eu- The Operating Components member's balance of payments and/or zone arrangement does not include all target zones. Until the participant coun- ropean currencies in the form of the of the ERM Conclusion the foreign-exchange reserve position. major currencies, it may be vulnerable tries can agree on these issues, realign- Exchange Rate Mechanism (ERM) of The Exchange Rate Mechanism consists As this brief review has suggested, the The European Monetary Cooperation to exchange-market pressures emanat- ments of ERM currencies, and the European Monetary System (EMS). of four major components: the European success of any target-zone arrangement Fund coordinates and facilitates all ing from outside. On occasion, worldwide exchange-rate fluctuations, A review of the ERM provides valuable Currency Unit, the parity grid, the di- for exchange rates depends on the abil- transactions. Official ECUs serve as a exchange-rate stability in the ERM has will be unavoidable. lessons about the operations, costs, and vergence indicator, and the credit facili- ity of participant countries to agree on means of settlement in these transac- benefits of target-zone arrangements. ties. Because we are interested in the tions. Each central bank deposits at least The European Monetary System be- exchange-rate management of the ERM, 20 percent of their gold and dollar re- gan operating in March 1979. Its pur- we briefly discuss the European Cur- serves with the European Monetary .W pose is to foster monetary stability in the rency Unit and then focus on the parity Cooperation Fund in exchange for offi- 8. See Deborah Danker, Richard A. Haas, Dale W. 9. See Francesco Gravazzi and Alberto Giovan- 10. Actually, a recent study argued that policy European Economic Community, which grid and the divergence indicators. Henderson, Steven A. Symansky and Ralph W. cial ECUs. nini, "The EMS and the Dollar," Economic Policy, cooperation could introduce an inflation bias to the is a prerequisite for achieving the eco- The European Currency Unit (ECU) Tryon, "Small Empirical models of Exchange No.2 (April 1986), Cambridge University Press, EMS. See Kenneth Rogoff, "Can International nomic and monetary union of Europe. is a composite currency, consisting of Market Intervention: Applications to Germany, London, pp. 455-484. Monetary Policy Coordination be Counterproduc- fixed amounts of 10 European curren- The Parity Grid Japan, and Canada," Board of Governors of the All members of the European Economic tive?" Journal of International Economics, May cies.' The quantity of each country's Subject to the agreement of all the par- Federal Reserve System, Staff Studies 135, April 1985, No. 3/4 pp. 199-218. Community, except Portugal, have 1985 and references. signed the EMS Agreement, but Greece, currency in the ECU reflects that coun- ticipants, each member of the exchange- Great Britain and Spain have opted not try's relative economic strength in the rate mechanism determines a central to participate in the Exchange Rate European community. The ECU func- exchange rate for its currency, which is Federal Reserve Bank of Cleveland BULK RATE Mechanism. 2 tions as an unit of account, as a means of denominated in currency units per Research Department U.S. Postage Paid The ERM has gone through some settlement, and as a reserve asset for the ECUs. These central rates attempt to members of the ERM. Recently, it has establish equilibrium exchange values PO. Box 6387 Cleveland, OH periods of strain and must still address received growing use as a unit of ac- for the currencies, but members can Cleveland, OH 44101 Permit No. 385 some difficult problems. Nevertheless, it has not degenerated into a system of count and as a means of payment in pri- seek adjustments to the central rates. frequent small exchange-rate adjust- vate transactions. Since the ECU is a The ERM countries have adjusted the ments, as some critics had forecast. On composite of many currencies, its ex- central rates 11 times since the establish- the contrary, according to some analysts change value is less prone to large ment of the EMS. With the most recent the ERM has reduced the volatility of exchange-rate swings than are individual realignment on January 12, 1987, the both nominal and real exchange rates in currencies. ECU central rates have been: 42.4582 large part by fostering the convergence Three short-term credit mechanisms Belgian francs, 7.85212 Danish kroner, of inflation and money growth rates enable one ERM member central bank to 2.05853 Deutsche marks, 6.90403 borrow funds from another to finance French francs, 2.31943 Dutch guilders, Nicholas V. Karamouzis is an assistant economic also thanks Gerald H. Anderson, Owen F Hum- I. See Owen F. Humpage and Nicholas Y. Kara- advisor with the Bank of Greece and a visiting page, and Mark Snidermanfor their comments. mouzis, "Target Zones for Exchange Rates?" scholar at the Federal Reserve Bank of Cleveland. The views stated herein are those of the author Economic Commentary, Federal Reserve Bank of Material may be reprinted provided that the Address Correction Requested: Please send The author benefited from his participation in the and not necessarily those of the Federal Reserve Cleveland, August I, 1986. source is credited. Please send copies of reprinted corrected mailing label to the Federal Reserve Foreign Exchange Group of Experts under the Bank of Cleveland, of the Board of Governors of materials to the editor. Bank of Cleveland, Research Department, Committee of the Central Banks of the Member the Federal Reserve System, or of the Bank of P.O.

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