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Managing currency bands and the future of European monetary integration.

Presents the likely future of European economic and monetary union given the present economic and political climate


In the latter part of the 1980s, member states of the European Community (EC) moved towards an explicit goal of monetary union. Heterogeneous economies, with histories of independent internal economic policies, are attempting the establishment of a common central bank to conduct, manage and control their monetary policies. Moreover, the impetus for the move towards a single currency in Europe stemmed from political conditions rather than economic conditions.

On 1 January 1993, the European Community was set to become a single integrated market as barriers to the union were scheduled to be eliminated. However, by late July 1993, the European Monetary System (EMS) threatened to unravel, as interest rate differentials continued to widen and European central banks' policies were neutralized by speculative attacks against their currencies in the foreign exchange markets. Consequently, the Exchange Rate Mechanism (ERM), which ties European Community members' currencies together, faced the possibility of collapse as the French franc, Spanish peseta, Portuguese escudo, and Danish krone were propelled perilously close to the permissible environs of fluctuation despite massive intervention by central banks. Similar conditions had forced the Italian lira and the British pound sterling out of the ERM in September 1992. But French withdrawal would have meant de facto dissolution of the EMS and put the future of European monetary union in jeopardy.

The short-term resolution of the crisis was the decision to widen the permissible bounds of fluctuation. This article examines the events leading to the ERM crisis. The implications of the crisis and its resolution on the future of European monetary integration are also scrutinized. In particular, we analyse the economic arguments concerning fixed versus flexible exchange rates within an economic union. Some discussion of the likely future of the European economic and monetary union is presented given the current economic and political climate of member countries. Finally, we argue that one of the major causes of the European foreign exchange chaos in recent years can be attributed to the disequilibrium imbalances of the current exchange rate arrangements among the European Community members.

Historical background of the European Monetary System

The EMS came into being in March of 1979, as a consequence of the large exchange rate fluctuations and variabilities of the community currencies during the early 1970s. The EMS was an outgrowth of the joint float (sometimes referred to as the "European snake" agreement) of the six currencies as a unit against other currencies developed during the twilight of the Bretton Woods regime. The renouncement of the Bretton Woods System in August 1971, and the subsequent "float" of major currencies against one another, was discerned by the European Economic Community as imperilling their basic goal to maintain an economic union. The so-called Smithsonian Agreement of December 1971 had established a realignment of exchange rates among the United States, Japan, and the major European countries (the so-called Group of Ten) after the earlier months of generalized floating. The exchange rate arrangement among the European countries was one in which the bilateral exchange rates of the European currencies involved would be maintained within close margins (the so-called snake), while the exchange rates against the dollar would be kept within twice those margins (the so-called tunnel). Therefore, the outcome was referred to as the "snake within the tunnel". However, its membership dwindled shortly after 1971 as countries abandoned their pegging margins against the US dollar or other European currencies. Ireland and the United Kingdom abandoned the snake by mid-1972, and Italy in 1973[1-3].

After 1973, the turbulent international monetary situation convinced the European member states that steps should be taken towards closer monetary cooperation for the purpose of insulating their domestic economies from the impacts of volatile international exchange rate markets. The EMS was established to achieve three major goals:

(1) enhance co-ordination of monetary and fiscal policies within the EC countries;

(2) stabilize fluctuations in exchange rates; and

(3) pave the way for European monetary union[4-6]. Exchange rate stability meant an "adjustable peg" system. Therefore, the European monetary system is basically a kind of "snake" as far as exchange rate arrangements are concerned. But it was to be more flexible than the snake by allowing wider margins of fluctuations for individual currencies.

The institutional facilitation of the EMS was the implementation of the European Currency Unit (ECU) or Ecu and the ERM[7]. The ECU is a composite currency that consists of specified amounts of gold and the currencies of the nine members then belonging to the EEC, namely, the Deutschmark, French franc, Italian lira, Belgian franc, Dutch guilder, Danish krone, Luxembourg franc, Irish pound, and British pound[8,9]. Each currency had a peg (a central rate) expressed in terms of the ECU. Around this central parity, each currency was kept within 2.25 per cent of the central rates against other members' currencies. Furthermore, there was a mechanism in place requiring central banks' actions as exchange rates approached the limits of divergence permitted from the central rates. However, the Spanish peseta, the Portuguese escudo, the Italian lira, and the Irish pound were allowed a 6 per cent margin. Should a currency approach 75 per cent of its margin - the so-called threshold of divergence - the country was compelled, under the agreements, to engage in either foreign exchange intervention or in local policies aimed at correcting this imbalance.

When the margins are approached and cannot be sustained, a realignment of the central rate may take place. This can be done only after consultation with other members. Although there were 12 realignments between 1979 and 1991, most occurred before 1987.

Several realignments took place during the ERM crisis of the autumn of 1992 which resulted in the eventual withdrawal of the United Kingdom and Italy from the ERM.

Realignments are viewed with disfavour, as a realignment of a national currency is perceived as a sign of political and macroeconomic policy failure. However, failure to undertake realignment viewed as necessary can create a flurry of speculation as the market "guesses" about likely changes in currency values. In the 1980s, countries were able to curb speculation through the use of capital controls. In 1992, the system came under pressure from two factors:

(1) German unification; and

(2) the abandonment of capital controls by the member countries as part of the Europe 1992 agenda with its free movement of goods, labour, and capital[10].

The EMS was meant to be only a transitional way station on the road to full monetary union. The EC has accepted the principles set out in the 1989 Delors Report as its blueprint to move towards European Monetary Union (EMU). These principles became part of the Maastricht Treaty to which the European leaders agreed in 1991. All member nations had ratified the treaty by 1993.

The Delors Report calls for a gradual, three-stage movement

The Delors Report calls for a gradual, three-stage movement to full monetary union. Stage I (up until December 1993) had the goal of abolishing all remaining capital controls (mainly affecting France and Italy) and securing the agreement for the establishment of a European Central Bank (ECB). Stage II (begun in January 1994) saw the establishment of the European Monetary Institute which co-ordinates co-operation between national central banks and, thus, serves as a precursor to the ECB. Stage III would result in full monetary union with a single common currency coordinated by the ECB. If most of the countries meet the standards for admission by 1996, then the process can start as early as that time however, this stage must begin by 1999[6, p. 130].

The "convergence criteria" - the conditions a country must meet prior to joining the union - are fairly daunting. They include the following:

* The inflation rate (consumer price inflation) must be no larger than 1.5 percentage points above the average for the three countries with the lowest rates in the EMS.

* The long-term interest rate (nominal) must be no higher than two percentage points above the average observed in the three countries with the lowest inflation rates.

* The country cannot have its currency devalued - i.e. no fluctuation beyond the [+ or -]2.25 band - within two years prior to entry into the union (no exchange rate realignments).

* The government budget deficit can be no more than 3 per cent of gross domestic production (GDP) (a general government deficit to GDP ratio).

* The government debt can be no more than 60 per cent of GDP.

The Maastricht Treaty, based on the Delors Report, incorporates these basic principles: that the road to full union will be gradual and admission can occur under different schedules for different countries[6,11,12]. Therefore, the criteria for EMU are low inflation, low budget deficits, a stable exchange rate, and public debts limited to 60 per cent of the country's GDP. However, as the data presented in Table I demonstrate, the member nations are not likely to meet the criteria in the near term.


The 1993 ERM crisis

The July/August ERM crisis was just the latest bump in the road to European monetary union. In September 1992, similar conditions of speculative attacks led to the eventual withdrawal of the British pound sterling and the Italian lira from the ERM. At the same time, Spain, Portugal and Ireland were forced to devalue their respective currencies.

The July/August ERM crisis was fundamentally the result of macroeconomic differences in the status of the European national economies, particularly the differences between the French and the German economies, and the aggravation caused by the external shock of German reunification. For France, 1993 was a period of recession. Unemployment was at 11.5 per cent and rising. The government deficit was approximately $70 billion. However, France's inflation rate was a mere 1.9 per cent, less than half of the German inflation rate. While the French deficit was large, it did not compare to the huge German deficit brought about by the reunification[13,14]. The domestic French political pressure was to lower interest rates to stimulate the economy. The difficulty for France, though, was that it was also committed to a strong franc, the so-called franc fort policy. If France lowered its interest rates without similar movement by the Germans, then the franc would be weakened with respect to the D-mark.

On the other hand, Germany has had the dominant role in the EMS. The D-mark serves as the anchor currency, and it might be argued that Germany controls European monetary policy. German reunification was an enormous external shock. The one-for-one swap of D-marks for East German marks resulted in a dramatic increase iii Germany's money supply and a huge government deficit. Consequently, the German inflation rate rose to 4.3 per cent, even as the economy was slipping into a downturn. While the German inflation rate may not seem all that high, Germany has a very low tolerance for inflation because of its historical experience. The German central bank, the Bundesbank, is constitutionally autonomous from the government, and traditionally (as well as constitutionally) has viewed its mission as the maintenance of price stability.

Currency speculators could also see the differences in economic circumstances between Germany and other ERM countries. In the summer of 1993, speculators were betting that domestic economic concerns would lead to lower interest rates in France, Spain, Portugal, Denmark and Belgium. They also knew that an attack on these currencies would trigger ERM-mandated interventions by the central banks. Thus, speculation was a fairly safe bet.

By the end of July, the French franc was moving perilously close to its floor with the D-mark At this time, the following alternatives faced the ERM member countries:

* reduction of German interest rates (the discount rate) by the Bundesbank to allow France and others to stay within the [+ or -]2.25 per cent band while still lowering their interest rates;

* realignment of the French franc and other currencies;

* suspension of the ERM.

The Bundesbank decided to close the door on lower interest rates and, thus, precipitated the ERM crisis. (Actually, the Bundesbank lowered the Lombard rate, the short-term interest rate ceiling, by 0.5 per cent but not the discount rate. Consequently, the effect was negligible[15].) Reacting to the news of Bundesbank intransigence, speculators began frantically selling French francs and other weak currencies to buy D-marks. The central banks began massive interventions, but finite reserves limited the scope of intervention effectiveness and currency values continued to fall.

Confronted with the impending destruction of the ERM, the finance ministers and central bankers met in Brussels during the weekend of 30 July-1 August. German officials proposed expanding the bands from [+ or -]2.25 per cent to [+ or -]6 per cent. France rejected this proposal as insufficient to head off further speculation and recommended a counter-proposal: to cut the D-mark loose from the ERM to float freely on its own. The Netherlands, which had pursued a policy of shadowing the D-mark, and Belgium threatened to leave the ERM if Germany was forced out. Spain, in turn, suggested dissolving the ERM completely[16].

The ministers and bankers eventually accepted the final French position of allowing currencies to fluctuate within a 30 per cent band around their central rate against the ECU. The communique released by the ministers characterized the action as being "of limited duration"[16]. The measure loosened the coupling of ERM currencies to the D-mark and cleared the path for lower interest rates. At the same time, the measure fended off "safe" speculation.

While criticized by some observers as a de facto suspension of the ERM, others argue that the [+ or -]15 per cent band is less than the degree of fluctuation exhibited by floating currencies, such as the dollar and yen. The most attractive aspect of this compromise for the participants is that the institutional framework of the EMS is maintained. Presumably, it would be much easier to narrow the bands at some later date than it would be to create a new regional system[16].

There was a need to rebuild the battered reserves

The short-term response to the widening of the exchange rate bands was both interesting and instructive. While Portugal has lowered its interest rates and Denmark has increased its rates, initially the general trend was to hold the course. There were several reasons for ERM members to maintain the high interest rates in the short term. First, there was a need to rebuild the battered reserves. Le Monde estimated that Banque de France spent the equivalent of $.50.6 billion to protect the franc. Similarly, the Bundesbank and the Danish National Bank pursued interventions that cost the equivalent of $,35.7 billion and $7.4 billion respectively[17]. Second, the weak currency countries were trying to avoid losses. To facilitate interventions, the central banks borrowed D-marks to buy their own currencies. Thus, it was in their own best interest to keep their currencies strong while their reserves were being rebuilt. Third, by moving cautiously in adjusting interest rates, some hoped that it would be easier to preserve the EMS. That is, slow interest rate movements would mitigate exchange rate fluctuations and thus smooth the transition back to narrower bands. The final reason for maintaining interest rates in the short term was revenge. The weak currency countries, especially France, wanted to shake out speculators before turning their attention to domestic economic concerns. On the other hand, Britain slashed its interest rate after sterling was forced out of the ERM in September 1992.

One final response is worthy of note. Despite considerable strain, the Franco-German alliance seems to have survived intact, at least in the short run. There seems to be a deep political understanding that this alliance may be the cornerstone for all future developments in the European Union (EU).

The implications of the ERM crisis

The implications of the ERM crisis fall into three categories:

(1) the controversy over fixed versus flexible exchange rates;

(2) the effects on national economies; and

(3) the significance for future monetary union.

Each will be analysed after brief discussion of the effectiveness of macroeconomic policy in open economies.

Fixed versus flexible exchange rates systems

The basic framework for analysing the impact of macroeconomic polides in an open economy is known as the Mundell-Fleming model[18,19]. This framework has been extended by many authors[2,20-23]. In this section, we analyse the dynamics of both fiscal and monetary policies on the national economies under flexible and fixed exchange rate systems.

An expansionary fiscal policy under fixed exchange rate system with perfect capital mobility tends to put an upward pressure on domestic interest rates as money demand expands[24]. This, in turn, results in an inflow of short-term capital. In order to maintain the fixed exchange rate, the monetary authority is forced to purchase the foreign currency surplus in exchange for its domestic currency. Consequently, the home money supply will expand. The additional expansionary effect of this involuntary increase in the domestic money supply explains why fiscal policy is more potent than under a floating rate. This process will continue as long as there are international interest rate differentials. It should be noted here that, with perfect capital mobility, the increase in the home GDP is made possible by the free inflow of short-term capital. However, in the absence of international capital movements, then the resulting increase in home interest rate would decrease investment spending in the domestic economy. This will offset the potential increase in the home GDP, making fiscal policy less effective in stimulating GDP and lowering unemployment.

On the other hand, expansionary fiscal policy with perfect capital mobility and flexible exchange rate system leads to a higher level of GDP and interest rates. The increase in government spending causes an improvement in the home country's balance of payments. This leads to an appreciation of the home currency. This process continues until the deterioration in the current account balance is sufficient to offset the initial expansion in fiscal policy. Therefore, the effectiveness of such policy under flexible exchange rate regimes depends heavily on the degree of international capital mobility.

With respect to monetary policy, flexible rates provide monetary authorities with the autonomy to conduct their own independent policies towards domestic inflation and unemployment. While under a fixed exchange rate system, monetary authorities are forced to buy or sell foreign currencies in order to keep the exchange rate steady. This means any attempt to increase (decrease) the money supply to lower (raise) interest rates will be neutralized by induced changes in the domestic money supply caused by foreign exchange intervention.

The European case

Under a fixed exchange rate system, such as the post-Second World War Bretton Woods system, central banks should stand ready to buy or sell their domestic currencies at a fixed price in terms of other currencies when market forces move the values of their exchange rates away from the predetermined fixed rates. In this environment, the limited autonomy of central banks over their monetary policy was made possible by the existence of capital controls. But, when capital is freely mobile across countries, any small differential in interest rates among countries can cause infinite capital flows. Consequently, with perfect capital mobility, central banks cannot influence their domestic macroeconomic variables by using monetary policy.

To see the outcome of this scenario, consider the EMS crisis in 1992. Germany tried to influence the domestic inflation by conducting contractionary monetary policy. This action resulted in an upward pressure on German interest rates. Immediately, portfolio holders and foreign exchange speculators worldwide shifted a great deal of their wealth to take advantage of higher rates. This event did result in huge capital inflow to Germany and a sharp increase in German balance of payments and, hence, an appreciating German mark against the world's major currencies, in general, and the other members of the EMS, in particular. Since exchange rates had to be kept within the [+ or -]2.25 band according to the rules of EMS, this forced other members to maintain high interest rates and, subsequently, the EMS members' central banks to intervene to hold the exchange rate constant. Germany's central bank intervened heavily in the foreign exchange market by buying the other members' currencies and selling its own. Other members, such as France and Britain, were also selling German marks from their international reserves and buying their own currencies to prevent any further speculative attacks on their own currencies.

One may wonder why the 1980s reflected a period of relative calm for the EMS. EMS member countries were allowed to change their central rates against one another when policy dissimilarities produced disequilibrium in their balance of payments. Overall economic conditions, especially in the later part of the decade, did not necessitate many such changes as the European economies grew steadily in concert. It has been argued that periods of exchange rate stability accompanied by occasional realignments were possible because of the relatively wide bands of fluctuation permitted[6,25] and because capital controls protected European central banks' reserves against speculative attacks motivated by the anticipation of realignment. The central issue here is that a fixed exchange rate system will be viewed as unstable if there are fundamental differences in the economic circumstances of member countries and there are no capital controls. In the minds of economic agents, such a system is not credible because there is the potential for currency realignment despite any avowed claims of the "fixity" of exchange rates.

Thus, while the fixed exchange rate system may create desirable certainties and remove transactions difficulties for trading partners, one might argue that the only way to achieve these objectives is to strive for a system with one currency controlled by one central bank given free capital flows in Europe. However, even if one assumes that all of Europe agreed to a "one European central bank - one currency" scenario, it would be impossible for such an institution to conduct policy aimed at the conflicting policy needs of all the different countries involved, some of which might have recession while others may suffer from inflation.

Effects on national economies

The EMS crisis underscores the differences in the national economies of Europe. Since German reunification, France and Germany have differed in terms of their economic fundamentals (deficit, inflation, and so forth). One also might argue that they differ in their inflation-unemployment trade-off preference[26]. Even their respective central banks are institutionally different: Banque de France is an arm of the government under the Ministry of Finance; the Bundesbank is autonomous, and constitutionally mandated to control domestic price stability[27,28].

Because of the linkages through ERM, it is difficult for countries to conduct monetary policies for domestic macroeconomic purposes. This is well illustrated in the French example: France's desire to stimulate its domestic economy through lower interest rates was thwarted by the ramifications for the exchange rate system, especially in the face of the Bundesbank's anti-inflation stance.

The temporary, expansion of permissible currency bands within the ERM allows weaker currency countries some protection against speculation while they attempt to pursue domestic macroeconomic goals through monetary policy. For example, given this wider band, France could presumably lower interest rates without the franc falling close to its floor. With the franc staying easily within the band, there is no threat of realignment, no central bank intervention, and, thus, speculation should be abetted, at least in the short run. At the same time, Germany is free to pursue anti-inflation measures, without having to commit large reserves to currency interventions. In short, the wider bands allow the ERM to act as a limited floating system, and provides its members with the capability of somewhat limited monetary policy intervention in their respective domestic economies.

Significance for monetary union

Will the ERM crisis lead to the destruction of the dream of European monetary union? The events of July and August 1993 do point to the central problem and the paradox of European economic integration. The national economies are vastly different, as are their respective inflation-unemployment trade-off preferences. German reunification presented Europe with an asymmetric shock and undermined Germany's leadership role in the EMS. It also clearly demonstrated the willingness of member states to place domestic goals above European interests. The paradox is that despite the differences, exacerbated by the reunification, Europe does function as a single market[29,30].

Inter-regional transfers could replace the use of divergent monetary policies

Conditions easing economic and monetary integration have been well documented[6,30,31]. Flexible wages and prices reduce the need for either monetary or fiscal policy to correct short-run macroeconomic imbalances. Similarly, temporary imbalances can be corrected through the migration of labour from contracting sectors (regions) to expanding ones. If the underlying economic fundamentals are similar across member states, real exchange rate will not need to fluctuate. To the extent there are dissimilarities, the existence of inter-regional transfers could replace the use of divergent monetary policies and exchange rate policies. It can be argued that economies that are "open" have little in the way of independent monetary policy even in the absence of any formal monetary agreement. Finally, if external shocks to the system impact all regions in a similar manner, obviously the resultant policy prescription would be similar across the member states of the "union".

Using these criteria, what can be inferred about conditions for a viable and acceptable European Monetary Union? Given the social security systems and labour organizations in place, wages and prices are not downwardly flexible in the EU. The mobility of labour across nations is low, arguably owing to cultural and language differences[32,33]. Most tax and transfer programmes remain at the national level. The EU budget is small relative to those of member states. Further, most of the EU budget reflects spending on the Common Agricultural Policy and little on the type of regional transfers envisioned as necessary under a monetary union. While the volume of intra-EU trade has continued to increase, i.e. the economies are increasingly open, intra-EU trade remains a relatively small percentage of GDP for member states such as Germany, France and the UK.

A realistic view would encompass a looser free trade area

The repercussions of German reunification clearly demonstrate that shocks can be asymmetric across the member states of the EU. Finally, member nations are subject to differing external shocks as they vary in the geographic markets in which they trade and in the mix of products they sell. The emergence of market economies in Eastern Europe is likely to deepen such differences.

The expansion of the EU is likely to heighten these tensions. While the admission of Austria, Finland, Norway and Sweden represents a logical expansion of the free trade area, even this was fraught with serious debate over the consequences of full economic and monetary union. Clearly, these issues will become more problematic as the emerging market economies of Eastern Europe seek fuller participation. Potential membership of Poland, the Czech Republic, and Hungary will be on the agenda for the EU in the not too distant future. These countries are extremely unlikely to meet the convergence criteria outlined in the Maastricht Treaty. Further, it is difficult to imagine that the degree of social cohesion envisioned for current member nations of the EU could be embraced readily by either side.

At the present time, the formal schedule outlined in the Maastricht Treaty is being followed. Currency markets have stabilized. However, an examination of the "economics" of European Monetary Union casts doubts on its potential success. A more realistic view would encompass a much looser free trade area. Within the FTA a core group of countries will be likely to forge stronger ties of full economic and monetary union. In the end, whether a single currency and the European Central Bank emerge at the end of the decade will depend more on the political goals of the EU members as time passes than on economics.

Concluding remarks

In reviewing the ERM crisis and exploring the resulting ramifications, a central theme emerges: that economic integration is as much about politics as it is about economics. When it comes to managing a fixed exchange rate regime, European governments have been forced to choose between their commitments to promote a single currency in Europe and their national obligations to achieve satisfactory economic performances at home. The political economy of Europe during the remainder of this decade will revolve around this struggle between the desires of individual nations to address their own domestic economic concerns and the aspirations for a united and enlarged European economy.

This article argues that the combination of the economic union with its free movement of capital and the ERM with its a fixed exchange rate regime creates an inherent credibility problem. The mobility of capital across borders can produce short-term capital flows which drive currency values away from their underlying equilibrium values owing to short-term interest rate differentials or the expectation of such differentials. The ERM crisis has highlighted the economic and political differences existing in Europe. The loosening of the bands to allow divergent monetary policies demonstrates the priority of domestic economic concerns over those of the European unity as a whole. Finally, despite avowed support by the EU political leadership, monetary union does not seem to be a viable option owing to the heterogeneity of EU domestic economies.

Notes and references

1. For more complete information, see Commission of the European Communities[2] and Bordo[3].

2. Commission of the European Communities, The European Monetary System, European File No. 15/86, Office for Official Publications of the European Communities, Luxembourg, October 1986.

3. Bordo, M.D., "The Gold Standard, Bretton Woods and other monetary regimes: an historical appraisal", National Bureau of Economics Research, Working Paper No. 4310, April 1993.

4. For discussion of background and structure of the EMS see: Frantianni and Von Hagan[5] and De Grauwe[6].

5. Frantianni, M. and Von Hagen, J., The European Monetary System and European Monetary Union, Westview Press, Boulder, CO, 1992.

6. De Grauwe, P., Economics of Monetary Integration, Oxford University Press, Oxford, 1992.

7. The name ECU is somewhat controversial. The Ecu is an old French coin, and the French prefer any future single currency of Europe to be called Ecu. However, the Germans want it to be ECU, or some other neutral name!

8. Even though the British pound formed part of the ECU in 1979, and the UK was a member of the EMS, Britain did not participate in the currency arrangements of the EMS until October 1990. For more details on the EMS, see Ungerer et al.[9].

9. Ungerer, H., Evans, O. and Nyberg, P., "The European monetary system: the experience, 1979-1982", IMF Occasional Paper, No. 19, May 1983.

10. Spain, Portugal and Ireland have resorted again to capital controls in order to shelter the ERM storm, but the cost has been high at least for Spain, where bonds and stock have fallen sharply as foreign investors have taken flight and it could take Spain years to regain their trust. However, without capital control, the mechanism can bring great losses of reserves in the countries of the weak currencies and high degree of liquidity in the strong ones.

11. See De Grauwe[6, pp. 131, 134]. Also, for the possibility of monetary unification by 1999, see Eichengreen[12].

12. Eichengreen, B., "European monetary unification", Journal of Economic Literature, Vol. 3, September 1993, pp. 1,321-57.

13. Sesit, M., "Currency markets cool despite loosened ERM", The Wall Street Journal, 3 August, 1993.

14. The Economist, "Defending the franc", 13 February 1993.

15. Whitney, G., "Weaker Mark, stalled Germany recovery expected in wake of currency crisis", The Wall Street Journal 9 August 1993.

16. The Economist, "In their hands?", 7 August 1993.

17. Gumbel, P., "Europe drags its feet on interest rates", The Wall Street Journal, 6 August 1993.

18. Mundell, R., "A theory of optimum currency areas", American Economic Review, Vol. 51, September 1961, pp. 657-65.

19. Mundell, R., "Capital mobility and stabilization under fixed and flexible exchange rates", Canadian Journal of Economics and Political Science, Vol. 29 No. 4, November 1963, pp. 475-85.

20. See Mundell[2] and Fleming[21]. This framework has been extended by many authors. See for example Dornbusch[22], and Flanders and Helpman[23].

21. Fleming, M., "Domestic financial policies under fixed and floating exchange rates", IMF Staff Papers, Vol. 9, November 1962, pp. 369-79.

22. Dornbusch, R., "Exchange rates and fiscal policy in a popular model of international trade", American Economic Review, December 1975, pp. 859-71.

23. Flanders, M.J. and Helpman, E., "On exchange rate policies for a small country", Economic Journal, March 1978, pp. 44-58.

24. A fixed exchange rate system requires that the interest rate parity should hold. Further, purchasing power parity should also hold, and the growth rate of money supply has to be consistent with the PPP. This may aggravate the problems of currency management in Europe. Countries have different currencies, reputation for financial stability, and tax systems which, in turn, will impact expectations about their future inflation and interest rates.

25. De Grauwe[6] points out that the relatively wide bands frequently meant that realignments could be accomplished without any immediate change in market exchange rates, i.e. there was an overlapping of the new and old bands reducing the gains from speculation.

26. Clearly, one can argue whether there is, in fact, a trade-off between inflation and the level of employment, even in the short run. However, the crucial issue here is whether political and economic decision makers act as if there is such a trade-off available in the formulation of economic policy.

27. For more discussion on the subject, see De Boissieu and Duprat[28].

28. De Boissieu, C. and Duprat, M.-H., "French monetary policy in the light of European monetary and financial integration", in Sherman, H.C. (Ed.), Monetary Implications of the 1992 Process, St Martin's Press, New York, NY, 1990.

29. While a full discussion of the costs and benefits of monetary integration are beyond the scope of this article, the literature identifies several factors as important in determining the viability of a monetary union: the degree of price and wage flexibility, the mobility of labour, the degree of convergence of the regions within the union; the existence and extent of regional transfer systems; the openness of the economies; and the extent to which external shocks are common to all regions. (For a fuller discussion, see Swann[30, pp. 254-63].)

30. Swann, D. (Ed.), The Single European Market and Beyond, A Study of the Wider Implications of the Single European Act, Routledge, London, 1992.

31. See De Grauwe[6] and Swann[30] for a fuller discussion.

32. Feldstein, M.[33] makes a strong argument against a single currency in Europe. He argues that a single currency may reduce intra-European trade for several reasons. The use of a single currency makes product specialization less attractive. Furthermore, complete labour mobility across the EU is a necessary condition for a single currency to be effective - a condition that is very unlikely to be met in Europe. Therefore, the lack of perfect labour mobility requires different monetary policies to reduce the impacts of external shocks on different countries and, hence, on different parts of the currency area.

33. Feldstein, M., "The case against EMU", The Economist, 13 June 1992, pp. 23-6.

Further reading

Collins, S. and Giavazzi, F., "Attitudes towards inflation and the viability of fixed exchange rates: evidence from the EMS", in Bordo, M. and Eichengree, B. (Eds), A Retrospective on the Bretton Woods System, University of Chicago Press, Chicago, IL, 1993, pp. 547-86.

Commission of the European Commission, "One market, one money", European Economy, No. 44, 1990.

Delors, J., "Report of economic and monetary union in the European Community", European Commission, The Delors Report, Office of Official Publications of the EC, Luxembourg, 1989.

The Economist, "The markets: shooting the messenger", 7 August 1993.

The Economist, "The Bundesbank: it was inscrutable to the end", 7 August 1993.

Giavazzi, F. and Spaventa, L., "The new EMS", in De Grauwe, P. and Papademos, L. (Eds), The European Monetary System in the 1990's, Longman, London, 1990, pp. 65-85.

International Financial Statistics, International Monetary Fund, Washington, DC, 1993, 1994.

Kaminow, I., "Economic stability under fixed and flexible exchange rates", Journal of International Economies, Vol. 9, 1979, pp. 277-85.

Melitz, J, "Monetary discipline, German and the European monetary system", in Francesco, G., Micossi, S. and Miller, M. (Eds), The European Monetary System, Cambridge Press, New York, NY, 1988.

Rogoff, K.; "The optimal degree of commitment to an immediate monetary target", Quarterly Journal of Economics, Vol. 100, November 1985, pp. 1,169-90.

Roth, T., "Kohl, playing down money crisis", The Wall Street Journal, 10 August 1993.

Jamal Abu-Rashed, Lance Cameron and Carol H. Rankin are all based at the College of Business Administration, Xavier University, Cincinnati, Ohio, USA.
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Author:Abu-Rashed, Jamal; Cameron, Lance; Rankin, Carol H.
Publication:Management Decision
Date:Mar 1, 1995
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