Lessons from the European Monetary System

Home , Belgian franc, European Currency Unit

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. Box 6387, Cleveland, OH 44101. States of the European Economic Community. He Greece. of the maximum possible movement. ods for relating economic variables to Table 1 Parity Grida When a currency crosses its "threshold Chart 1 The Narrow Band on May 26,1987* exchange rates and, therefore, have no German~ Denmark Ireland France of divergence," the authorities of the Percent precise way of determining the "equilib- country concerned should implement rium" value of exchange rates. At a + 2.25 3.9016 .38182 3.4305 corrective policies. minimum, participating countries DM Central rate 1 3.81443 .37328 3.35386 On several occasions, however, the 1.87% ·2.25 3.7300 .36496 3.2792 should cooperate and develop methods d~vergence indicator has failed to pro- of monitoring economic developments VIde an early warning signal. In part, the + 2.25 .26810 1 .10008 .89225 in order to identify at an early stage widespread practice of intramarginal DKr Central rate .26216 .09786 .87925 possible signs of tension in the ERM. intervention distorts the signal, but the ·2.25 .25630 .09568 .85970 Although some exchange-rate adjust- indicator also suffers from inherent tech- ment is unavoidable when national eco- + 2.25 2.740 10.451 9.1890 nical problems. 7 The ERM members nomic experiences conflict, the ERM Irish pound Central rate 2.678 10.2186 1 8.9848 need to modify the divergence indicator has no formal rules for determining the -2.25 2.619 9.9913 8.7850 and to develop new indicators that trig- timing and magnitude of realignments in ger consultation and policy responses central rates. In the past, ERM countries + 2.25 .30495 1.1632 .11383 among the participants . adjusted their central rates to offset dif- FF Central rate .298164 1.13732 .111299 1 ferentials among their inflation rates. 1.1120 -2.25 .29150 .108825 The Functioning of the System This strategy implicitly provided a quan- When a ERM currency diverges too far titati ve guide and a justification for a. All exchange rates are expressed in terms of national currencies rather than in terms of ECUs. from the central cross rates, appropriate Belgian Irish D-Mark Guilder French Kroner exchange-rate realignments. Now that SOURCE: Author. countries must introduce policies to Franc Pound Franc relative money growth rates and inflation rates within the ERM have become reduce the pressure on the exchange SOURCE: Author. "The Italian lira is not included. more similar, realignments might be 0.798411 Irish pounds and 1483.58 Ital- ERM currency relative to the weakest rates. European policy makers generally can employ three complimentary poli- smaller and less frequent than in the ian liras. currency in the group. It expresses the past. cies to deal with short-term pressures on exchange-rate stability afforded by any As a result, small profit opportunities These central rates establish a grid of weakest currency's market exchange On the other hand, it could be harder their exchange rates: 1) intramarginal target-zone arrangement requires a coor- will induce large capital movements bilateral cross exchange rates among the rate vis-a-vis each participant currency for the countries involved to agree on intervention, 2) fuller use of the dination of economic-policy objectives. which, other things equal, will require currencies. For example, 2.05853 as a percentage deviation from the weak- new central rates. At the January 1987 exchange-rate bands and intervention at Nations should achieve convergence of larger amounts of intervention to defend Deutsche marks per ECU divided by est currency's central rate vis-a-vis each realignment, for example, France and the compulsory margins, and 3) adjust- those economic variables that directly the parities. The experience with the 7.85212 Danish kroner per ECU equals participant currency. Germany disagreed sharply over which ment of interest rates. affect exchange rates, such as fiscal January 12, 1987 realignment confirms 0.262162 marks per kroner, which also Chart 1 shows the relative position of country's policies had caused the ex- Although experience varies, most deficits, current-account imbalances, this view. In January, the volume of implies 3.81443 kroners per mark (See ERM currencies against the Belgian change problem and, consequently, on ERM countries adopt intramarginal in- and real economic growth differentials. speculative capital movements over- table 1). franc, on May 26, 1987. As the chart which country should adjust and by how tervention as the first line of defense. Among the ERM countries, the fun- whelmed attempts to stabilize exchange Nations participating in the ex- indicates, the Danish kroner was the much. The ERM countries eventually Central banks of relevant countries un- damental nonmonetary determinants of rates through intervention. change-rate mechanism agree to keep strongest currency in the ERM on that agreed that the German mark would be dertake such intervention and usually do exchange rates are slowly converging. Exchange-rate stability requires that their currencies within a 2.25 percent day, with the Danish kroner/Belgian revalued, along with the Belgian franc not coordinate their activities with other Although monetary policies also have interest-rate policies be coordinated and margin on either side of these central franc rate deviated 1.87 percent from the become more similar, the participants do geared towards maintaining exchange- and the Dutch guilder. cross exchange rates, except Italy which ERM central banks. Danish kroner/Belgian franc central not agree that zero inflation should be rate parities. But there are differences of Target-zone arrangements generally has 6 percent margins. 5 If market pressure persists, usually rate." All will lie within a band of 2.25 the ultimate objective of the European opinion among ERM members. Ger- specify in very broad terms that partici- Continuing our example, if the Dan- the central banks of the "weak" curren- percent, except possibly the Italian lira. Economic Community. Consequently, many is reluctant to adjust interest rates pants should adjust economic policies ish kroner should strengthen against the cies allow their exchange rates to move when exchange rates threaten to break closer to the lower boundary of the band monetary authorities in the ERM coun- downward when the Deutsche mark is Deutsche mark and reach the upper in- through the bands. Typically, however, a The Divergence Indicator and/or adjust their domestic interest tries often face a policy dilemma be- under upward pressure, because it tervention limit, the Bundesbank will disproportionately large share of the Each member of the ERM must inter- tween exchange-rate stability and claims that such actions could jeopard- sell kroner to commercial banks at 3.73 rates upward. The aim is to penalize adjustment burden has fallen on the vene when its currency reaches the 2.5 interest-rate stability, and face a conflict ize domestic price stability. Similarly, kroners per mark, while Denmark's speculators by making speculation "weak" currency countries. percent band against any other ERM between domestic and external objec- others are reluctant to increase interest National Bank will buy marks at 0.26810 costly and less rewarding. If such poli- Countries with appreciating curren- currency. Ideally, ERM members would tives. rates when their currencies depreciate kroners per mark. cies do not stem the pressure on the ex- cies, trade surpluses and increases in like to know when pressure is building The European experience has shown because they fear a detrimental impact It is rare for an exchange rate to move change rate, or if the relevant countries reserves are less prone to adjust than on their exchange rates, so that they that an aggressive interest-rate policy is on their budget deficits and on their from the lower band to the top band (4.5 cannot implement the appropriate poli- countries with depreciating currencies, could take corrective action before their the most effective means of stabilizing domestic economic activity. A few percent) against a single currency. If the cies because of political or domestic trade deficits, or reserve losses. This exchange rates reach the 2.5 percent exchange rates, particularly when coun- countries, like the Netherlands, allow Deutsche mark started strengthening policy constraints, then EMS members view is supported by the convergence of bands. The divergence indicator at- eventually will need to realign the cen- tries coordinate their policies. The need domestic interest rates to move widely from the lower limit against the Danish for such coordinated policies has in- to contain exchange-rate pressures. inflation rates among the ERM coun- kroner, it probably would reach an upper tempts to provide such an early warning tral rates. signal. creased as EMS countries have lifted Economic convergence takes time; in tries. An equal sharing of the adjustment intervention limit against another cur- burden implies that rates of inflation Basically, the divergence indicator restrictions on capital flows. Almost all the meantime, realignments may be rency before it reaches the upper limit among the participant countries would measures the amount that an exchange Observations on the ERM EMS countries have liberalized restric- unavoidable. If financial and real shocks against the Danish kroner. converge to the average rate. rate actually has moved from its central The ERM provides valuable insights tions on capital flows related to com- predominate over monetary shocks as A convenient way to monitor the Germany, however, has maintained a rate, expressed as a percentage of the into the operations of target-zone ar- mercial transactions and to long-term the major source of exchange-rate insta- relative position of each currency in the domestic monetary target of low or zero maximum movement allowable under rangements, and illustrates the problems financial transactions. Most countries bility, policymakers will find it hard to band is to construct the so-called "nar- inflation, and often has refused to alter the 2.5 percent bands. A "threshold of that such mechanisms are likely to en- anticipate further liberalization of re- determine the need for and proper mag- row band of fluctuations." Usually the counter. Perhaps the most important strictions against short-term financial nitude of an exchange-rate realignment. domestic monetary policy because of narrow band shows the position of each divergence" is established at 75 percent lesson that the ERM illustrates is that the flows in the near future. Unfortunately, we have no precise meth-

2. Throughout this paper, ERM refers to countries 3. See Horst Ungerer, Owen Evans, Thomas 4. For details about the ECU, see: The ECU, 5. The figure ± 2.25 percent is only an approxi- 6. This is calculated as follows: The Danish 7. See Roland Vaubel. "The Return to the New participating in the Exchange Rate Mechanism. Mayer and Philip Young. "The European Monetary European Documentation No. 6/84 (51pp.), Euro- mation. To preserve symmetry, the actual limits are kroner/Belgian franc market rate on May 26th was European Monetary System Objectives, Incen- They are: Belgium-Luxembourg, Denmark, System: Recent Developments," IMF Occasional pean Community Information Service, Washing- 2.27531 above, and 2.22469 below the central 0.18147651; the central cross rate was 0.1849376. tives, Perspective," Carnegie Rochester Confer- France, the Federal Republic of Germany, Ireland, Paper No. 48, December 1986. ton, D. C. rates. Subtracting the ratio: 0.18147651/0.1849376 from ence Series on Public Policy 13(Autumn 1980), Italy, and the Netherlands. EMS refers to countries one yields 0.0187 or 1.87 percent. In a similar way, pp. 173-221. that are members of the European Monetary we can calculate the deviations of the other ERM System. currencies from the Belgian franc. of the maximum possible movement. ods for relating economic variables to Table 1 Parity Grida When a currency crosses its "threshold Chart 1 The Narrow Band on May 26,1987* exchange rates and, therefore, have no German~ Denmark Ireland France of divergence," the authorities of the Percent precise way of determining the "equilib- country concerned should implement rium" value of exchange rates. At a + 2.25 3.9016 .38182 3.4305 corrective policies. minimum, participating countries DM Central rate 1 3.81443 .37328 3.35386 On several occasions, however, the 1.87% ·2.25 3.7300 .36496 3.2792 should cooperate and develop methods d~vergence indicator has failed to pro- of monitoring economic developments VIde an early warning signal. In part, the + 2.25 .26810 1 .10008 .89225 in order to identify at an early stage widespread practice of intramarginal DKr Central rate .26216 .09786 .87925 possible signs of tension in the ERM. intervention distorts the signal, but the ·2.25 .25630 .09568 .85970 Although some exchange-rate adjust- indicator also suffers from inherent tech- ment is unavoidable when national eco- + 2.25 2.740 10.451 9.1890 nical problems. 7 The ERM members nomic experiences conflict, the ERM Irish pound Central rate 2.678 10.2186 1 8.9848 need to modify the divergence indicator has no formal rules for determining the -2.25 2.619 9.9913 8.7850 and to develop new indicators that trig- timing and magnitude of realignments in ger consultation and policy responses central rates. In the past, ERM countries + 2.25 .30495 1.1632 .11383 among the participants . adjusted their central rates to offset dif- FF Central rate .298164 1.13732 .111299 1 ferentials among their inflation rates. 1.1120 -2.25 .29150 .108825 The Functioning of the System This strategy implicitly provided a quan- When a ERM currency diverges too far titati ve guide and a justification for a. All exchange rates are expressed in terms of national currencies rather than in terms of ECUs. from the central cross rates, appropriate Belgian Irish D-Mark Guilder French Kroner exchange-rate realignments. Now that SOURCE: Author. countries must introduce policies to Franc Pound Franc relative money growth rates and inflation rates within the ERM have become reduce the pressure on the exchange SOURCE: Author. "The Italian lira is not included. more similar, realignments might be 0.798411 Irish pounds and 1483.58 Ital- ERM currency relative to the weakest rates. European policy makers generally can employ three complimentary poli- smaller and less frequent than in the ian liras. currency in the group. It expresses the past. cies to deal with short-term pressures on exchange-rate stability afforded by any As a result, small profit opportunities These central rates establish a grid of weakest currency's market exchange On the other hand, it could be harder their exchange rates: 1) intramarginal target-zone arrangement requires a coor- will induce large capital movements bilateral cross exchange rates among the rate vis-a-vis each participant currency for the countries involved to agree on intervention, 2) fuller use of the dination of economic-policy objectives. which, other things equal, will require currencies. For example, 2.05853 as a percentage deviation from the weak- new central rates. At the January 1987 exchange-rate bands and intervention at Nations should achieve convergence of larger amounts of intervention to defend Deutsche marks per ECU divided by est currency's central rate vis-a-vis each realignment, for example, France and the compulsory margins, and 3) adjust- those economic variables that directly the parities. The experience with the 7.85212 Danish kroner per ECU equals participant currency. Germany disagreed sharply over which ment of interest rates. affect exchange rates, such as fiscal January 12, 1987 realignment confirms 0.262162 marks per kroner, which also Chart 1 shows the relative position of country's policies had caused the ex- Although experience varies, most deficits, current-account imbalances, this view. In January, the volume of implies 3.81443 kroners per mark (See ERM currencies against the Belgian change problem and, consequently, on ERM countries adopt intramarginal in- and real economic growth differentials. speculative capital movements over- table 1). franc, on May 26, 1987. As the chart which country should adjust and by how tervention as the first line of defense. Among the ERM countries, the fun- whelmed attempts to stabilize exchange Nations participating in the ex- indicates, the Danish kroner was the much. The ERM countries eventually Central banks of relevant countries un- damental nonmonetary determinants of rates through intervention. change-rate mechanism agree to keep strongest currency in the ERM on that agreed that the German mark would be dertake such intervention and usually do exchange rates are slowly converging. Exchange-rate stability requires that their currencies within a 2.25 percent day, with the Danish kroner/Belgian revalued, along with the Belgian franc not coordinate their activities with other Although monetary policies also have interest-rate policies be coordinated and margin on either side of these central franc rate deviated 1.87 percent from the become more similar, the participants do geared towards maintaining exchange- and the Dutch guilder. cross exchange rates, except Italy which ERM central banks. Danish kroner/Belgian franc central not agree that zero inflation should be rate parities. But there are differences of Target-zone arrangements generally has 6 percent margins. 5 If market pressure persists, usually rate." All will lie within a band of 2.25 the ultimate objective of the European opinion among ERM members. Ger- specify in very broad terms that partici- Continuing our example, if the Dan- the central banks of the "weak" curren- percent, except possibly the Italian lira. Economic Community. Consequently, many is reluctant to adjust interest rates pants should adjust economic policies ish kroner should strengthen against the cies allow their exchange rates to move when exchange rates threaten to break closer to the lower boundary of the band monetary authorities in the ERM coun- downward when the Deutsche mark is Deutsche mark and reach the upper in- through the bands. Typically, however, a The Divergence Indicator and/or adjust their domestic interest tries often face a policy dilemma be- under upward pressure, because it tervention limit, the Bundesbank will disproportionately large share of the Each member of the ERM must inter- tween exchange-rate stability and claims that such actions could jeopard- sell kroner to commercial banks at 3.73 rates upward. The aim is to penalize adjustment burden has fallen on the vene when its currency reaches the 2.5 interest-rate stability, and face a conflict ize domestic price stability. Similarly, kroners per mark, while Denmark's speculators by making speculation "weak" currency countries. percent band against any other ERM between domestic and external objec- others are reluctant to increase interest National Bank will buy marks at 0.26810 costly and less rewarding. If such poli- Countries with appreciating curren- currency. Ideally, ERM members would tives. rates when their currencies depreciate kroners per mark. cies do not stem the pressure on the ex- cies, trade surpluses and increases in like to know when pressure is building The European experience has shown because they fear a detrimental impact It is rare for an exchange rate to move change rate, or if the relevant countries reserves are less prone to adjust than on their exchange rates, so that they that an aggressive interest-rate policy is on their budget deficits and on their from the lower band to the top band (4.5 cannot implement the appropriate poli- countries with depreciating currencies, could take corrective action before their the most effective means of stabilizing domestic economic activity. A few percent) against a single currency. If the cies because of political or domestic trade deficits, or reserve losses. This exchange rates reach the 2.5 percent exchange rates, particularly when coun- countries, like the Netherlands, allow Deutsche mark started strengthening policy constraints, then EMS members view is supported by the convergence of bands. The divergence indicator at- eventually will need to realign the cen- tries coordinate their policies. The need domestic interest rates to move widely from the lower limit against the Danish for such coordinated policies has in- to contain exchange-rate pressures. inflation rates among the ERM coun- kroner, it probably would reach an upper tempts to provide such an early warning tral rates. signal. creased as EMS countries have lifted Economic convergence takes time; in tries. An equal sharing of the adjustment intervention limit against another cur- burden implies that rates of inflation Basically, the divergence indicator restrictions on capital flows. Almost all the meantime, realignments may be rency before it reaches the upper limit among the participant countries would measures the amount that an exchange Observations on the ERM EMS countries have liberalized restric- unavoidable. If financial and real shocks against the Danish kroner. converge to the average rate. rate actually has moved from its central The ERM provides valuable insights tions on capital flows related to com- predominate over monetary shocks as A convenient way to monitor the Germany, however, has maintained a rate, expressed as a percentage of the into the operations of target-zone ar- mercial transactions and to long-term the major source of exchange-rate insta- relative position of each currency in the domestic monetary target of low or zero maximum movement allowable under rangements, and illustrates the problems financial transactions. Most countries bility, policymakers will find it hard to band is to construct the so-called "nar- inflation, and often has refused to alter the 2.5 percent bands. A "threshold of that such mechanisms are likely to en- anticipate further liberalization of re- determine the need for and proper mag- row band of fluctuations." Usually the counter. Perhaps the most important strictions against short-term financial nitude of an exchange-rate realignment. domestic monetary policy because of narrow band shows the position of each divergence" is established at 75 percent lesson that the ERM illustrates is that the flows in the near future. Unfortunately, we have no precise meth-

2. Throughout this paper, ERM refers to countries 3. See Horst Ungerer, Owen Evans, Thomas 4. For details about the ECU, see: The ECU, 5. The figure ± 2.25 percent is only an approxi- 6. This is calculated as follows: The Danish 7. See Roland Vaubel. "The Return to the New participating in the Exchange Rate Mechanism. Mayer and Philip Young. "The European Monetary European Documentation No. 6/84 (51pp.), Euro- mation. To preserve symmetry, the actual limits are kroner/Belgian franc market rate on May 26th was European Monetary System Objectives, Incen- They are: Belgium-Luxembourg, Denmark, System: Recent Developments," IMF Occasional pean Community Information Service, Washing- 2.27531 above, and 2.22469 below the central 0.18147651; the central cross rate was 0.1849376. tives, Perspective," Carnegie Rochester Confer- France, the Federal Republic of Germany, Ireland, Paper No. 48, December 1986. ton, D. C. rates. Subtracting the ratio: 0.18147651/0.1849376 from ence Series on Public Policy 13(Autumn 1980), Italy, and the Netherlands. EMS refers to countries one yields 0.0187 or 1.87 percent. In a similar way, pp. 173-221. that are members of the European Monetary we can calculate the deviations of the other ERM System. currencies from the Belgian franc. 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,