Exchange Rate Policy Options of the European Central Bank

  M07555 International Finance and Investment Oxford Brookes University  

Table of Contents

I.  Executive summary  1

1.  Introduction  2

2.  Development of the euro since 1999  2

2.1  The path of the euro  3

2.2  Explanations of the weakness of the euro  4

3.  Exchange rate policy-making in the EMU  8

3.1  Floating exchange rates  8

3.2  Managed floating exchange rates  11

3.3  Fixed Exchange rates  12

3.4  Fixed Rates with Bands  15

4.  Keynes vs. Neoclassic - Market interventions  15

4.1  Options for market intervention  16

5.  Recommendation for a future exchange rate policy  18

II.  Bibliography  20

M07555 International Finance and Investment Oxford Brookes University

I. Executive summary

Since the euro has been introduced as the common currency of the European Monetary Union (EMU) exchange rate policy-making has not been noticeably mentioned on the agenda of the European Central Bank (ECB). This work examines and explains the development of the euro since its introduction in 1999. A discussion of possible exchange rate regimes, their impacts on domestic and international trade and living standards, as well as a brief introduction on market intervention will put forward a recommendation to the ECB for its future exchange rate policy.

Since most of the past currency crises emerged from monetary systems of fixed exchange rates, empirical data suggests a non fixed external regime to the EMU, even more since this allows a range of steering and counteracting opportunities.

Following the Keynesian monetary theory, the forces of supply and demand are not always sufficient to guarantee a stable and sound economic environment for successful trade and growth. Therefore a free floating system of exchange rates might not be the right way for the ECB to follow its aim of price stability and competitiveness in a highly integrated area as the EU.

We recommend employing an external managed floating system at a reasonably high level of currency value, i.e. purchasing power, depending on the situation of employment and export-import balance. The ECB should carefully carry out market interventions, limited by international exchange rate agreements, e.g. by the G-10 Nations summits.

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M07555 International Finance and Investment Oxford Brookes University

1. Introduction

This paper will start with a brief description of the path of the euro since its introduction in 1999. We explain which factors might have had an impact on the value and its recent development.

Explaining the existing models of exchange rate regimes we will analyse their economic effects on domestic and international markets and living standards. Then we will discuss the option of market interventions.

Finally, taking the current situation and the economic environment of the EMU into account, we will recommend a future exchange rate policy for the ECB.

2. Development of the euro since 1999

Following the former ECU, the euro has been introduced in two steps:

In 1999, the euro was first established as a common transaction currency by 11 members in the EMU. Denmark, Sweden and the United Kingdom stayed outside, using their options in the Maastricht contracts. Greek was not able to participate since they failed the convergence criteria. A common central bank, the ECB was founded in order to care for stability and sustainable economic growth. The second step was taken in 2002, when the euro was introduced as real money, replacing the former currencies at a fixed rate.

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M07555 International Finance and Investment Oxford Brookes University

2.1 The path of the euro

When the euro was first introduced, many analysts predicted a strong euro that would remain at or above parity with the U.S. dollar. Some analysts even anticipated that the euro might be strong enough to become a key "reserve" currency like the U.S. dollar. However, the euro has declined steadily from its initial value of $1.16 in January 1999. The euro depreciated until it reached an all time low in October 2000 when its value was only $0.85, almost a 30-percent drop from January 1999. The euro continued to remain below its initial value, usually fluctuating between $0.85 and $1.00, through June 2002. The following chart shows the value of the euro against the U.S. dollar, Japanese yen, and British pound sterling since the beginning of 1999. In September 2000, the sharp decline of the euro prompted the ECB to raise short-term interest rates to halt the euros slide.

M07555 International Finance and Investment Oxford Brookes University

2.2 Explanations of the weakness of the euro

How should these discrepancies be explained in economic terms?

• Firstly, some evidence suggests that the depreciation of the euro has at least partly been due to its being overvalued at the time of its introduction. But of course, there is no exact means of calculating equilibrium exchange rates, and the range of estimates that have been made for the euros value in dollar terms is very wide, from $1.26 to $0.87, though it should be said that the latter is based only on tradable goods and services. However, taking purchasing-power parity based on GDP as a best estimate, the OECD calculated this to suggest an exchange rate of €1 = $1.06 in 1999.

• Secondly, it was only to be expected that, in its early stages, the euro would not immediately attain the same acceptance as the deutschmark used to have when it was the dominant currency in the calculation base for the ECU. The fact that there is no national sovereign body to back up the European Central Bank (ECB) and that the bank first needed to build up its own policy-making credibility is likely to have influenced some market participants to exercise restraint with regard to investment in the euro zone. The lack of transparency in the ECB’s decision-making since it took office has not exactly helped to enhance this reputation.

• Thirdly, there may have been other economic reasons for the declining exchange rate which the estimating equation does not adequately take into consideration, such as the pronounced increase in the price of oil in the early part of the year 2000. In the first half of 2000, it reached the $30-per-barrel mark for the first time since the Gulf crisis in the early 1990s, and because petroleum bills are

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