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The European monetary system
Journal of Banking and Finance 12 (1988) 50542.
THE EUROPEAN
North-Holland
MONETARY
SYSTE
A Note
M. Keivan DERAVI Auburn University, Montgomery, AL 361934401, USA
Massoud METGHALCHI a
University of Hawaii, Hilo, HI 9672l$ USA
Received May 1985, final version received September W&7 This paper investigates the performance of the EMS since its implementation in 1979. The statistical results suggest that there has been a significant decrease in bilateral and effective exchange rates variabilities of the participatingcountries. The test results also point toward a narrowerdivergence in the development of national monetary policies across’ERM countries.
1. Imltroductioa
Although the origins for some form of European union are fairly distant, it has only been during the twentieth century, and particularly since World War II, that a host of schemes have been put forward to foster European integration through an economic and monetary union. At first, the European approach to unification relied on the dynamic effects of functional spill-over, which forced member countries to extend cooperation to new fields of economic activities [Tsoukalis (1977)]. This worked well in the early years; the coal and steel market could not subsist by itself and induced the search for an integration of all economic sectors. Later, the European Economic Community (EEC) led to the creation of the Common Agricultural Policy. This, in turn, exposed the shortcomings of the absence of monetary cooperation in the Community. The first two attempts toward monetary cooperation, the Werner Plan. and the Snake arrangement, were unsuccessful. The European Monetary System (EMS), which was launched in March 1979, can be seen as the latest attempt to move to more advanced stages of monetary integration. The EMS is designed to achieve intra-EEC exchange rate stability and harmonization of monetary policies. These proclaimed goals of the EMS are indispensable preconditions for a move further along the roa of monetary union. G3784266/88/$3.50 Q 1988, Elsevier Science Publishers B.V. (North-Holland)
506
M.K. Deravi and M. Metghalchi, The European Monetary System
This paper is an attempt to assess the performance of the EMS by examining the extent to which exchange rate stability and convergence of economic policies within the participating countries have been achieved. The paper is organized into four sections. Section 2 provides a brief discussion of the main features of the EMS. Section 3 compares the variability of exchange rates in the EMS for the pre- and post-1979 time period; this section also focuses on convergence of economic development between EMS countries. Finally, a conclusion is presented in section 4. ain featves of the EMS
The main objective of the EMS is to achieve a zone of monetary stability in Europe. It is the central component of a grand strategy aimed at ‘lasting growth with stability, a progressive return to full employment, the harmonization of living standards and the lessening of regional disparities in the community’ [European Economy (1979, p. 94)]. The EMS contains three parts: an exchange rate mechanism (ERM); the creation of the European Currency Unit (ECU); and the first steps toward the European Monetary Fund (EMF). The ERM is a system of fixed but adjustable exchange rates. Each participating currency has a central rate expressed in terms of the ECU from which central bilateral rates are derived. The exchange rate mechanism specifies a band or margin around the central bilateral rates within which market rates are free to fluctuate. The band is 2.25 percent on either side of the central rates, with two exceptions. The Italian lira is set at 6 percent. Also, the UK, although a member of the EMS, decided not to participate in the ERM; however, the pound sterling is included in the basket of currencies that forms the ECU. The member countries have a responsibility to intervene only at the margin. The responsibility is shared by both the weak and strong currencies. On the other hand, there is no sharing of responsibility for i&imarginal interventions. The ECU, a basket of ten member currencies, has two functions. It serves both as a numeraire and as a basic divergent indicator. As a numeraire, the ECU is used to define the central rates. As divergent indicator, the ECU value of any currency’s market value outside the threshold divergence - set at 75 percent of the allowable margin -- signals authorities to bring that currency’s policies in line with those of other members [Ungerer, Evans and Nyberg (1983)]. The EMS also assumes the creation of the EMF in order to consolidate the credit mechanisms into a single fund. It should evolve to a supernational monetary authority for the Community with the power to create new international reserves [Padoa-Schioppa (1980)]. ereas under the nake arrangeme t ttiere was a bias toward the policy
M.K. Deravi and M. Metghalchi, The European Monetary System
507
Table 1 Variabihtyof nominal (bilateral)exchange rates of EEC countries against the deutschmark. Italy
Netherlands U.K. Si
Six excluding U.K.
1.2 2.9 0.8 1.9 4.1 1.7 0.5 0.8 1.0 0.9 0.7 F? 0.1 0.6
3.8 2.2 1.1 4.2 1.4 1.8 1.0 0.6 1‘2 0.8 0.6 0.6 0.9 0.2
1.8 0.9 0.4 0.6 0.6 0.4 0.5 0.4 0.4 0.6 0.4 0.7 0.1 0.08
3.4 9.9 20 2.9 1.3 2.4 2.2 2.6 3.1 1.7 2.5 1.1 2.2 2.5
2.1 22 0.9 1.8 1.5 1.2 1.0 0.8 1.1 1.0 0.8 0.6 0.6 0.6
1.8 1.6 0.7 1.6 1.6 1.0 0.7 0.5 0.8 0.9 0.5 0.5 0.3 0.3
2.2 0.5
1.1 0.5
0.6 0.4
2.6 1.7
1.5 0.6
1.3 0.5
Belgium Denmark France 1.0
1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986
1.2 1.0 0.4 0.5 0.7 0.4 0.5 0.3 0.8 1.3 0.4 0.3 0.3 0.2
1.2 0.8 0.7 1.1 0.8 1.1 0.4 0.6 0.7 0.3 0.5 03 OYi
72.1l-79.3 79.4-86.12
0.6 0.5
0.4
1973
3.9
stance of low-inflation countries, the operation of the divergent indicator within the EMS was designed to favor the policy stance most widely adopted by member countries. Under the EMS rules a country with a divergent currency was supposed to correct the situation by appropriate measures. The divergence indicator, however, never performed the function for which it was created and over time it has become a ‘supplementary device’. Some of the many reasons for the failure of this mechanism are: (a) the problem of determining the partner currency for intervention remains unsolved; (b) the indicator, by virtue of its design - being a composite of all currencies - can respond properly only when one currency is divergent from the average of the other currencies; and (c) differential treatment of the Italian lira and inclusion of pound sterling - which does not participate in ERM - have at times resulted in some distortions [e.g. Rey (1982), Salop (1981), Thygesen (1979)]. 3. Performance of the EMS The founding fathers of the EMS argued that the exchange rate system and the ECU divergence indicator should enhance rates stability and the convergence of monetary policy within the Community, This section examines the variability of exchange rates before and after the implementation of the EMS. An indicator of exchange rate variability is computed for alternative measures of exchange rates, and the results are presented in tables 1 and 2. The measure of exchange rates volatility used in these tables is the monthly average absolute percentage change
508
M.K.
Deravi
and
M. Metghalchi, The
Ewopean
Monetary
System
Table 2 Variabilityof effectiveexchange rates of EEC countries. Belgium Denmark France
Italy
Netherlands U.K. Six
Six excluding U.X.
1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986
0.7 0.9 0.8 1.1 0.5 1.0 0.5 0.7 0.8 1.4 0.7 0.6 0.7 0.5
1.3 1.2 0.9 1.0 1.4 0.9 1.0 1.0 1.5 1.2 1.0 0.8 1.2 0.8
1.5 1.8 1.2 1.1 0.3 1.1 0.6 0.8 1.4 1.3 1.0 1.0 1.0 0.8
2.r t.4 0.3 2.9 0.8 0.8 0.4 0.9 1.4 0.7 0.8 0.6 0.7 1.0
1.4 0.8 1.4 1.1 0.6 1.0 0.6 0.7 1.3 0.5 0.6 0.9 1.1 0.7
1.4 0.6 0.9 21 0.8 1.2 1.7 1.2 1.8 1.1 1.7 1.0 20 1.8
1.5 1.2 0.9 1.5 0.7 1.0 0.8 0.9 1.4 1.0
1.6 1.3 0.9 1.4 0.7 1.0 0.7 0.8 1.3 1.0
:: 1:r 0.9
:: 1:o 0.8
73.2-79.3 79.4-86.12
0.8 0.7
1.1 1.1
1.1 1.0
1.3 0.8
1.0 0.8
1.2 1.6
1.1 1.0
1.1 0.9
AAPC(X)=Tl - l- x. (IX,-XJ). X S’ 1
t-1
loo
.
>
Table 1 compares the volatility of bilateral nominal exchange rates of ERM currencies against the Deutschmark. A comparison of the average magnitudes of exchange rate chanc:q indicates that the monthly AAPC for France decreased from 2.2 percent in the 65 months before the ~tablishment of the EMS (1972.11-1979.3) to 0.5 percent in the subsequent period. For Italy the monthly AAPC decreased from 2.1 percent in the former ~riod to 0.5 percent in the latter. A closer look at table 1 reveals that for %elgium, Denmark, the Netheriands and the U.K. exchange rate variability has not decreased much since 1979. This is not surprising since the first three countries were part of the old Snake arrangement and the U.K. does not participate in the exchange rate mechanism which constitute the bulk of the EMS agreement. For the six countries as a wh&, the msnthiy AAPC dropped from 1.5 percent in the 1972.11-1979.3 CEO 0.6 percent in the 1979.44986.12 period. For all participating countries in the exchange rate system (excluding the U.K.) the AAPC dropped from 1.3 percent to 0.5 percent - a decrease of more than 50 percent. This indicates that bilateral exchange rate variability has been reduced since March 1979. Table 2 compares the volat%ty of effective exchange rates of EEC countries. In general, the earlier results are confirmed. Namely, the monthly
AAPC for France, Italy, and the Netherlands dropped by 10, 30, L. *a percent, respectively. Table 2 also indicates that the volatility of the pound ste&g, a non-participant currency in the ERM, has increased by 45 percent. By comparing this increa ttiity of the pound sterling to the more stable exchange rates of the participating countries one can protie strong evidence in support of the EMS. For all participating countries in the EMS the AAPC dropped by almost 20 percent. The drop in vari ty in this case, however, is less than that of nominal exchange rates. This is not surprising because the behavior of the effective rate index, which includes non-ERM currencies has been afkcted fess by the creation of the EMS than the bilateral rates of member countries.1 Having concluded that the EMS had successfully reduced the variability of the exchange rates of the EEC countries this paper focuses on the question of the convergence of the monetary policy within the Community. Table 3 presents a measure of dispersion of the rate of increases in Consumer Price Indices, rates of growth in MI and the domestic component of the monetary base, and the levels of interest rates of the EEL” countries for the prep and post-1979 periods. The variability is measured as the variance of the ratio of each country’s indicator against the average for the Community in each period. An examination of table 3 shows that the divergence of the interest rates, both at the long and short end, and the rates of growth of the domestic companent of the monetary base - both in real and nominal terms - have narrowed. No improvement in convergence in inflation rates is found for the pot-1979 period. Finally, the variability of M1, measured in real and nornina terms, is found to be higher in the 19804985 period as compared wit’itithe pre-EMS period. The results reported in table 3 are similar to those of De Grauwe, F,rantianni and NabiJi (1985), Russo (1986), and Ungerer, Evans, Mayer and Young (1986). With the exception of the ratb of increases in J&Z_!, the overall picture that emerges from table 3 is one of more convergence of policies in the ERM countries in the post-EMS period. However, the observed increased variation in A41does not point, necessarily, toward less harmony in monetary policies of the ERM countries. This is because of two reasons. First, after the March 1983 realignment, the EMS has been moving more and more towards a system of fixed exchange rates. In a fixed exchange rate regime, monetary policy has to be subordinated to the external objectives; consequently, a greater deviation from the average by any member of the ERM may reflect not ‘lessconvergence, but more [Ungerer, Evans, Meyer and Young (~986)]. ‘A similar m-we of variability was computed for the real exchange rates of EEC countries. The results confirmed the findings of tables 1 and 2. That is, there was a drop in variability of exchange rates for France, Italy, and Denmark. The same trend was also observed for the overall variability of all countries combined.
0.18 2.19 0.09 112.10 1.17 0.19 0.05 0.26 1.16 0.26 14.59 1.19 0.32 0.10
1977 0.29 1.10 0.30 1.17 1.12 0.29 0.12 0.24 1.43 0.22 42.62 1.16 0.29 0.09 0.30 7.56 0.55 10.09 0.19 0.07 0.09
1979 0.30 2.18 0.84 2.65 0.67 0.07 0.07
1980 0.19 2.53 0.57 0.25 1.06 0.06 0.07
1981 0.17 13.76 0.37 47.74 0.45 0.13 0.11
1982 0.29 1.51 0.14 12.46 0.48 0.21 0.09
1983
0.20 3.89 0.79 2.50 0.35 0.18 o.!l6
0.28 3.96 1.34 6.64 2.31 0.15 0.06
0.25 5.06 0.66 11.$8 0.79 0.12 0.08
Avg. 1984 1985 198s1985
Source: IMP: International
Financial Statistics, selected years.
-
-.
“Variability is measured as the variance of each country’s indicator against the average of EEC countries in each period. “Belgium, Denmar k, France, Germany, Italy, and the Netherlands. The data on U.K., Ireland, and Luxembourg are excluded. U.K. has not participated in the exchange rate system; Ireland and Luxembourg are excluded in view of their small sixes. ‘The above table was reconstructed using the variance of EEC countries against Germany. The results were similar to table 3. “Rate of increase.
CPP Weal Wd Nominal Mid Real domestic monetary based Nominal domestic monetary based Short-term interest rates Long-term interest rates
1976
Avg. 1978 1976-1978
Table 3 Variance of selective economic indicators of EEC countries against the average of EMS countriePb*’
M.K. Deravi and M. Metghalchi, The European Monetary System
511
Given this, a better measure of convergence in monetary policies would be the variability of the domestic components of the monetary base, since this variable largely excludes the influence of the external sector. An examination of table 3 shows that the convergences in the real and nominal domestic components of monetary base have improved, respectively, by over 70 and 30 percent from the 1976-1978 period to the 1979-1985 period. Second, as argued bv Dooley and Spinelli (1985), financial innovation in the late 1970s and early i%% has tended to make the money stock a less reliable intermediate target for monetary policy. As a result, monetary authorities participating in the EMS have focused more on interest rates than on money supplies as intermediate targets to keep the system together. In light of this, the variance in the interest rates, before and after the E-MS, is perhaps a better indication of convergence in the ERM countries. Table 3 shows that both short- and long-term interest rates moved closer together in the later period than in the former. This is another piece of evidence supporting the thesis that there has been more convergence in developments of monetary policies in the ERM countries sincfs the implementation of the EMS in 1979. Finally, the variance in inflation rates is found to increase by four percent in the post-1979 period. The earlier discussion - narrowing divergence in the monetary policies of the ERM countries - suggests that this lack of improvement in reducing the variability of inflation rates may be the result of non-monetary policies. The empirical findings of Ungerer, Evans, QIayer and Young (1986) seem to support this argument. They find that the average fiscal deficits have widened in ERM countries in 1979-1984 as compared with the earlier period. Tbis failure to overco,ne the differences in 5scal policies appears to have some bearings (though inflationary expectation) in convergence in the long-term interest rates. More specifically, table 3 shows a sharper decline in variance of the short-term than that of the long-term interest rates. 4. Conclusion
It is now possible to say, more than seven years after its inception, that the EMS appears a success. Short-run (monthly) fluctuations of EMS currencies against the Deutschmark have been aubstantially lower relative to the pre1979 time period. In fact, the inception of the EMS has resulted in a significantly lower exchange risk among ERM countries. We also find that convergence in monetary policy has increased, as shown by the observed decrease in the variabilities of the domestic component of the monetary base and interest rates since 1979. Despite the slightly higher variability in inflation rates, the real exchange rate is shown to be more stable for the post-1979 period. Real exchange rate stability in the EMS
512
M.K. Denwi and M. Metghdchi, The European Monetary System
emerges because nominal exchange rates may have adjusted quickly enough to the underlyin trends of national price levels, thus resulting in a lower exchange risk (measured in real terms) among ERM countries. What remains to be seen is whether individual members will be prepared to move towards the second and more ambitious stage in which the establishment of EMF and the use of ECU as a reserve asset is considered. Now that the second enlargement of the EEC has been completed by the absorption of Greece, Spain, and Portugal the transition to the second stage should become more difficult.
Bank of En&&. j9&1, The variability of exchange rates: Measurement and ef%cts,Quarterly Bulletin, Septy 346-349. Cal&i, S., F. Spinelli and G. Verga, 1984, Money demand in Italy: A few more results, Manchester School of Economics ar.3 Social Studies 52, no. 2, June, 141-159. Congress of the United States, Joint &onomic Committee, 1979, The European Monetary System: Problems and prospect (Government Printing Q&e, Washington, DC). De Grauwe, P., M. Frantianni and M.K. Nabii, 1985, Exchange rates, money and output: The European experience (St. Martin’s Press, New York). Dooiey, M.P. and F. Spin&, 1985, Financial innovation, deregulation and money demand in France, Italy and Japan, DM/85/15 (International Monetary Fund, Washington, DC). European Economy, The European Monetary System - commentary, documents, 1979, European Economy 3, July, 63-111. PadoaSchioppa, T., 1980, The EMF: Topics for discussion, Banca Naxionale de1 Larvaro, Quarterly Review, Sept., 317-343. Rey, JJ., 1982, Some comments on the merits and limits of the indicator of divergence of the European Monetary System, Revue de La Banque 1,3-15. Root, F., 1984, International trade and investment (South-Western Publishing Co, Cincinnati, OH). Russo, M., 1986, Why the time is ripe, Lecture delivered to the Bow Group, May 19 (House of Commons, London). Salop, J., 1981, The divergence indicators A technicaI note, International Monetary Fund Staff Papers 28, Dec., 682697. Steinherr, A., 1984, Convergence and coordination of macro-economic policies: Some basic issues, European Economy 20, July, 71-110. Thygesen, N., 1979,The emerging monetary system: Precursors,first steps and policy options, in: R. Tiffin,ed., EMS, The emerging monetary system (National Bank of Belgium, Brussels). Tsoukalis, L., 1977, The politics and economics of European monetary integration (Allen and Unwin, London). Ungerer, H., 0. Evans and P. Nyberg, 1983, The European Monetary System: The experience, 1972-82, Occasional paper no. 19 (InternationalMonetary Fund, Washington, DC). Ungerer, H., 0. Evans, T. Mayer and P. Yottng, 1986, The European Monetary System: Recent developments, Occasional paper no. 48 (InternationalMonetary Fund, Washington,DC).
THE EUROPEAN
North-Holland
MONETARY
SYSTE
A Note
M. Keivan DERAVI Auburn University, Montgomery, AL 361934401, USA
Massoud METGHALCHI a
University of Hawaii, Hilo, HI 9672l$ USA
Received May 1985, final version received September W&7 This paper investigates the performance of the EMS since its implementation in 1979. The statistical results suggest that there has been a significant decrease in bilateral and effective exchange rates variabilities of the participatingcountries. The test results also point toward a narrowerdivergence in the development of national monetary policies across’ERM countries.
1. Imltroductioa
Although the origins for some form of European union are fairly distant, it has only been during the twentieth century, and particularly since World War II, that a host of schemes have been put forward to foster European integration through an economic and monetary union. At first, the European approach to unification relied on the dynamic effects of functional spill-over, which forced member countries to extend cooperation to new fields of economic activities [Tsoukalis (1977)]. This worked well in the early years; the coal and steel market could not subsist by itself and induced the search for an integration of all economic sectors. Later, the European Economic Community (EEC) led to the creation of the Common Agricultural Policy. This, in turn, exposed the shortcomings of the absence of monetary cooperation in the Community. The first two attempts toward monetary cooperation, the Werner Plan. and the Snake arrangement, were unsuccessful. The European Monetary System (EMS), which was launched in March 1979, can be seen as the latest attempt to move to more advanced stages of monetary integration. The EMS is designed to achieve intra-EEC exchange rate stability and harmonization of monetary policies. These proclaimed goals of the EMS are indispensable preconditions for a move further along the roa of monetary union. G3784266/88/$3.50 Q 1988, Elsevier Science Publishers B.V. (North-Holland)
506
M.K. Deravi and M. Metghalchi, The European Monetary System
This paper is an attempt to assess the performance of the EMS by examining the extent to which exchange rate stability and convergence of economic policies within the participating countries have been achieved. The paper is organized into four sections. Section 2 provides a brief discussion of the main features of the EMS. Section 3 compares the variability of exchange rates in the EMS for the pre- and post-1979 time period; this section also focuses on convergence of economic development between EMS countries. Finally, a conclusion is presented in section 4. ain featves of the EMS
The main objective of the EMS is to achieve a zone of monetary stability in Europe. It is the central component of a grand strategy aimed at ‘lasting growth with stability, a progressive return to full employment, the harmonization of living standards and the lessening of regional disparities in the community’ [European Economy (1979, p. 94)]. The EMS contains three parts: an exchange rate mechanism (ERM); the creation of the European Currency Unit (ECU); and the first steps toward the European Monetary Fund (EMF). The ERM is a system of fixed but adjustable exchange rates. Each participating currency has a central rate expressed in terms of the ECU from which central bilateral rates are derived. The exchange rate mechanism specifies a band or margin around the central bilateral rates within which market rates are free to fluctuate. The band is 2.25 percent on either side of the central rates, with two exceptions. The Italian lira is set at 6 percent. Also, the UK, although a member of the EMS, decided not to participate in the ERM; however, the pound sterling is included in the basket of currencies that forms the ECU. The member countries have a responsibility to intervene only at the margin. The responsibility is shared by both the weak and strong currencies. On the other hand, there is no sharing of responsibility for i&imarginal interventions. The ECU, a basket of ten member currencies, has two functions. It serves both as a numeraire and as a basic divergent indicator. As a numeraire, the ECU is used to define the central rates. As divergent indicator, the ECU value of any currency’s market value outside the threshold divergence - set at 75 percent of the allowable margin -- signals authorities to bring that currency’s policies in line with those of other members [Ungerer, Evans and Nyberg (1983)]. The EMS also assumes the creation of the EMF in order to consolidate the credit mechanisms into a single fund. It should evolve to a supernational monetary authority for the Community with the power to create new international reserves [Padoa-Schioppa (1980)]. ereas under the nake arrangeme t ttiere was a bias toward the policy
M.K. Deravi and M. Metghalchi, The European Monetary System
507
Table 1 Variabihtyof nominal (bilateral)exchange rates of EEC countries against the deutschmark. Italy
Netherlands U.K. Si
Six excluding U.K.
1.2 2.9 0.8 1.9 4.1 1.7 0.5 0.8 1.0 0.9 0.7 F? 0.1 0.6
3.8 2.2 1.1 4.2 1.4 1.8 1.0 0.6 1‘2 0.8 0.6 0.6 0.9 0.2
1.8 0.9 0.4 0.6 0.6 0.4 0.5 0.4 0.4 0.6 0.4 0.7 0.1 0.08
3.4 9.9 20 2.9 1.3 2.4 2.2 2.6 3.1 1.7 2.5 1.1 2.2 2.5
2.1 22 0.9 1.8 1.5 1.2 1.0 0.8 1.1 1.0 0.8 0.6 0.6 0.6
1.8 1.6 0.7 1.6 1.6 1.0 0.7 0.5 0.8 0.9 0.5 0.5 0.3 0.3
2.2 0.5
1.1 0.5
0.6 0.4
2.6 1.7
1.5 0.6
1.3 0.5
Belgium Denmark France 1.0
1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986
1.2 1.0 0.4 0.5 0.7 0.4 0.5 0.3 0.8 1.3 0.4 0.3 0.3 0.2
1.2 0.8 0.7 1.1 0.8 1.1 0.4 0.6 0.7 0.3 0.5 03 OYi
72.1l-79.3 79.4-86.12
0.6 0.5
0.4
1973
3.9
stance of low-inflation countries, the operation of the divergent indicator within the EMS was designed to favor the policy stance most widely adopted by member countries. Under the EMS rules a country with a divergent currency was supposed to correct the situation by appropriate measures. The divergence indicator, however, never performed the function for which it was created and over time it has become a ‘supplementary device’. Some of the many reasons for the failure of this mechanism are: (a) the problem of determining the partner currency for intervention remains unsolved; (b) the indicator, by virtue of its design - being a composite of all currencies - can respond properly only when one currency is divergent from the average of the other currencies; and (c) differential treatment of the Italian lira and inclusion of pound sterling - which does not participate in ERM - have at times resulted in some distortions [e.g. Rey (1982), Salop (1981), Thygesen (1979)]. 3. Performance of the EMS The founding fathers of the EMS argued that the exchange rate system and the ECU divergence indicator should enhance rates stability and the convergence of monetary policy within the Community, This section examines the variability of exchange rates before and after the implementation of the EMS. An indicator of exchange rate variability is computed for alternative measures of exchange rates, and the results are presented in tables 1 and 2. The measure of exchange rates volatility used in these tables is the monthly average absolute percentage change
508
M.K.
Deravi
and
M. Metghalchi, The
Ewopean
Monetary
System
Table 2 Variabilityof effectiveexchange rates of EEC countries. Belgium Denmark France
Italy
Netherlands U.K. Six
Six excluding U.X.
1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986
0.7 0.9 0.8 1.1 0.5 1.0 0.5 0.7 0.8 1.4 0.7 0.6 0.7 0.5
1.3 1.2 0.9 1.0 1.4 0.9 1.0 1.0 1.5 1.2 1.0 0.8 1.2 0.8
1.5 1.8 1.2 1.1 0.3 1.1 0.6 0.8 1.4 1.3 1.0 1.0 1.0 0.8
2.r t.4 0.3 2.9 0.8 0.8 0.4 0.9 1.4 0.7 0.8 0.6 0.7 1.0
1.4 0.8 1.4 1.1 0.6 1.0 0.6 0.7 1.3 0.5 0.6 0.9 1.1 0.7
1.4 0.6 0.9 21 0.8 1.2 1.7 1.2 1.8 1.1 1.7 1.0 20 1.8
1.5 1.2 0.9 1.5 0.7 1.0 0.8 0.9 1.4 1.0
1.6 1.3 0.9 1.4 0.7 1.0 0.7 0.8 1.3 1.0
:: 1:r 0.9
:: 1:o 0.8
73.2-79.3 79.4-86.12
0.8 0.7
1.1 1.1
1.1 1.0
1.3 0.8
1.0 0.8
1.2 1.6
1.1 1.0
1.1 0.9
AAPC(X)=Tl - l- x. (IX,-XJ). X S’ 1
t-1
loo
.
>
Table 1 compares the volatility of bilateral nominal exchange rates of ERM currencies against the Deutschmark. A comparison of the average magnitudes of exchange rate chanc:q indicates that the monthly AAPC for France decreased from 2.2 percent in the 65 months before the ~tablishment of the EMS (1972.11-1979.3) to 0.5 percent in the subsequent period. For Italy the monthly AAPC decreased from 2.1 percent in the former ~riod to 0.5 percent in the latter. A closer look at table 1 reveals that for %elgium, Denmark, the Netheriands and the U.K. exchange rate variability has not decreased much since 1979. This is not surprising since the first three countries were part of the old Snake arrangement and the U.K. does not participate in the exchange rate mechanism which constitute the bulk of the EMS agreement. For the six countries as a wh&, the msnthiy AAPC dropped from 1.5 percent in the 1972.11-1979.3 CEO 0.6 percent in the 1979.44986.12 period. For all participating countries in the exchange rate system (excluding the U.K.) the AAPC dropped from 1.3 percent to 0.5 percent - a decrease of more than 50 percent. This indicates that bilateral exchange rate variability has been reduced since March 1979. Table 2 compares the volat%ty of effective exchange rates of EEC countries. In general, the earlier results are confirmed. Namely, the monthly
AAPC for France, Italy, and the Netherlands dropped by 10, 30, L. *a percent, respectively. Table 2 also indicates that the volatility of the pound ste&g, a non-participant currency in the ERM, has increased by 45 percent. By comparing this increa ttiity of the pound sterling to the more stable exchange rates of the participating countries one can protie strong evidence in support of the EMS. For all participating countries in the EMS the AAPC dropped by almost 20 percent. The drop in vari ty in this case, however, is less than that of nominal exchange rates. This is not surprising because the behavior of the effective rate index, which includes non-ERM currencies has been afkcted fess by the creation of the EMS than the bilateral rates of member countries.1 Having concluded that the EMS had successfully reduced the variability of the exchange rates of the EEC countries this paper focuses on the question of the convergence of the monetary policy within the Community. Table 3 presents a measure of dispersion of the rate of increases in Consumer Price Indices, rates of growth in MI and the domestic component of the monetary base, and the levels of interest rates of the EEL” countries for the prep and post-1979 periods. The variability is measured as the variance of the ratio of each country’s indicator against the average for the Community in each period. An examination of table 3 shows that the divergence of the interest rates, both at the long and short end, and the rates of growth of the domestic companent of the monetary base - both in real and nominal terms - have narrowed. No improvement in convergence in inflation rates is found for the pot-1979 period. Finally, the variability of M1, measured in real and nornina terms, is found to be higher in the 19804985 period as compared wit’itithe pre-EMS period. The results reported in table 3 are similar to those of De Grauwe, F,rantianni and NabiJi (1985), Russo (1986), and Ungerer, Evans, Mayer and Young (1986). With the exception of the ratb of increases in J&Z_!, the overall picture that emerges from table 3 is one of more convergence of policies in the ERM countries in the post-EMS period. However, the observed increased variation in A41does not point, necessarily, toward less harmony in monetary policies of the ERM countries. This is because of two reasons. First, after the March 1983 realignment, the EMS has been moving more and more towards a system of fixed exchange rates. In a fixed exchange rate regime, monetary policy has to be subordinated to the external objectives; consequently, a greater deviation from the average by any member of the ERM may reflect not ‘lessconvergence, but more [Ungerer, Evans, Meyer and Young (~986)]. ‘A similar m-we of variability was computed for the real exchange rates of EEC countries. The results confirmed the findings of tables 1 and 2. That is, there was a drop in variability of exchange rates for France, Italy, and Denmark. The same trend was also observed for the overall variability of all countries combined.
0.18 2.19 0.09 112.10 1.17 0.19 0.05 0.26 1.16 0.26 14.59 1.19 0.32 0.10
1977 0.29 1.10 0.30 1.17 1.12 0.29 0.12 0.24 1.43 0.22 42.62 1.16 0.29 0.09 0.30 7.56 0.55 10.09 0.19 0.07 0.09
1979 0.30 2.18 0.84 2.65 0.67 0.07 0.07
1980 0.19 2.53 0.57 0.25 1.06 0.06 0.07
1981 0.17 13.76 0.37 47.74 0.45 0.13 0.11
1982 0.29 1.51 0.14 12.46 0.48 0.21 0.09
1983
0.20 3.89 0.79 2.50 0.35 0.18 o.!l6
0.28 3.96 1.34 6.64 2.31 0.15 0.06
0.25 5.06 0.66 11.$8 0.79 0.12 0.08
Avg. 1984 1985 198s1985
Source: IMP: International
Financial Statistics, selected years.
-
-.
“Variability is measured as the variance of each country’s indicator against the average of EEC countries in each period. “Belgium, Denmar k, France, Germany, Italy, and the Netherlands. The data on U.K., Ireland, and Luxembourg are excluded. U.K. has not participated in the exchange rate system; Ireland and Luxembourg are excluded in view of their small sixes. ‘The above table was reconstructed using the variance of EEC countries against Germany. The results were similar to table 3. “Rate of increase.
CPP Weal Wd Nominal Mid Real domestic monetary based Nominal domestic monetary based Short-term interest rates Long-term interest rates
1976
Avg. 1978 1976-1978
Table 3 Variance of selective economic indicators of EEC countries against the average of EMS countriePb*’
M.K. Deravi and M. Metghalchi, The European Monetary System
511
Given this, a better measure of convergence in monetary policies would be the variability of the domestic components of the monetary base, since this variable largely excludes the influence of the external sector. An examination of table 3 shows that the convergences in the real and nominal domestic components of monetary base have improved, respectively, by over 70 and 30 percent from the 1976-1978 period to the 1979-1985 period. Second, as argued bv Dooley and Spinelli (1985), financial innovation in the late 1970s and early i%% has tended to make the money stock a less reliable intermediate target for monetary policy. As a result, monetary authorities participating in the EMS have focused more on interest rates than on money supplies as intermediate targets to keep the system together. In light of this, the variance in the interest rates, before and after the E-MS, is perhaps a better indication of convergence in the ERM countries. Table 3 shows that both short- and long-term interest rates moved closer together in the later period than in the former. This is another piece of evidence supporting the thesis that there has been more convergence in developments of monetary policies in the ERM countries sincfs the implementation of the EMS in 1979. Finally, the variance in inflation rates is found to increase by four percent in the post-1979 period. The earlier discussion - narrowing divergence in the monetary policies of the ERM countries - suggests that this lack of improvement in reducing the variability of inflation rates may be the result of non-monetary policies. The empirical findings of Ungerer, Evans, QIayer and Young (1986) seem to support this argument. They find that the average fiscal deficits have widened in ERM countries in 1979-1984 as compared with the earlier period. Tbis failure to overco,ne the differences in 5scal policies appears to have some bearings (though inflationary expectation) in convergence in the long-term interest rates. More specifically, table 3 shows a sharper decline in variance of the short-term than that of the long-term interest rates. 4. Conclusion
It is now possible to say, more than seven years after its inception, that the EMS appears a success. Short-run (monthly) fluctuations of EMS currencies against the Deutschmark have been aubstantially lower relative to the pre1979 time period. In fact, the inception of the EMS has resulted in a significantly lower exchange risk among ERM countries. We also find that convergence in monetary policy has increased, as shown by the observed decrease in the variabilities of the domestic component of the monetary base and interest rates since 1979. Despite the slightly higher variability in inflation rates, the real exchange rate is shown to be more stable for the post-1979 period. Real exchange rate stability in the EMS
512
M.K. Denwi and M. Metghdchi, The European Monetary System
emerges because nominal exchange rates may have adjusted quickly enough to the underlyin trends of national price levels, thus resulting in a lower exchange risk (measured in real terms) among ERM countries. What remains to be seen is whether individual members will be prepared to move towards the second and more ambitious stage in which the establishment of EMF and the use of ECU as a reserve asset is considered. Now that the second enlargement of the EEC has been completed by the absorption of Greece, Spain, and Portugal the transition to the second stage should become more difficult.
Bank of En&&. j9&1, The variability of exchange rates: Measurement and ef%cts,Quarterly Bulletin, Septy 346-349. Cal&i, S., F. Spinelli and G. Verga, 1984, Money demand in Italy: A few more results, Manchester School of Economics ar.3 Social Studies 52, no. 2, June, 141-159. Congress of the United States, Joint &onomic Committee, 1979, The European Monetary System: Problems and prospect (Government Printing Q&e, Washington, DC). De Grauwe, P., M. Frantianni and M.K. Nabii, 1985, Exchange rates, money and output: The European experience (St. Martin’s Press, New York). Dooiey, M.P. and F. Spin&, 1985, Financial innovation, deregulation and money demand in France, Italy and Japan, DM/85/15 (International Monetary Fund, Washington, DC). European Economy, The European Monetary System - commentary, documents, 1979, European Economy 3, July, 63-111. PadoaSchioppa, T., 1980, The EMF: Topics for discussion, Banca Naxionale de1 Larvaro, Quarterly Review, Sept., 317-343. Rey, JJ., 1982, Some comments on the merits and limits of the indicator of divergence of the European Monetary System, Revue de La Banque 1,3-15. Root, F., 1984, International trade and investment (South-Western Publishing Co, Cincinnati, OH). Russo, M., 1986, Why the time is ripe, Lecture delivered to the Bow Group, May 19 (House of Commons, London). Salop, J., 1981, The divergence indicators A technicaI note, International Monetary Fund Staff Papers 28, Dec., 682697. Steinherr, A., 1984, Convergence and coordination of macro-economic policies: Some basic issues, European Economy 20, July, 71-110. Thygesen, N., 1979,The emerging monetary system: Precursors,first steps and policy options, in: R. Tiffin,ed., EMS, The emerging monetary system (National Bank of Belgium, Brussels). Tsoukalis, L., 1977, The politics and economics of European monetary integration (Allen and Unwin, London). Ungerer, H., 0. Evans and P. Nyberg, 1983, The European Monetary System: The experience, 1972-82, Occasional paper no. 19 (InternationalMonetary Fund, Washington, DC). Ungerer, H., 0. Evans, T. Mayer and P. Yottng, 1986, The European Monetary System: Recent developments, Occasional paper no. 48 (InternationalMonetary Fund, Washington,DC).