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N° 1997 - 12 |
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| June |
| The Euro and Exchange Rate Stability |
Agnès Bénassy-Quéré
Be
noît Mojon
Jean Pisani-Ferry |
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The move to monetary union in Europe will
represent a major change for the International Monetary System. Indeed, it will
be the first time that large countries give up their national currencies to create
a new, common money. This paper investigates the impact it will have on global
exchange rate stability. More precisely, we examine whether the real exchange
rate of the euro vis-à-vis third currencies will in the long run be more or less
stable than the average real exchange rate of the corresponding basket of European
currencies.
The reasons for investigating this issue are twofold. First, it is sometimes argued that EMU could give rise to a transfer of volatility, i.e. that the removal of exchange rate instability within Europe could result in a higher instability between Europe and the rest of the world. Second, it is also argued that the euro zone would be larger and mechanically less open than the constituting member countries, the European Central Bank could be less interested in achieving exchange rate stability. Thus, a kind of reciprocal benign neglect could develop between Europe and the US. This paper introduces a simple analytical model to investigate the effect of European monetary union on the real effective exchange rate of the euro zone.
The world economy is made up of three countries called France, Germany and the US, which are linked through goods and capital markets. For each domestic economy, the nominal wage is fixed in the short run and clears the labour market in the long run. The supply-curve is therefore positively sloped in the short run, while it is vertical in the long run. Demand reacts positively to a depreciation of the real effective exchange rate (REER) and negatively to an increase in the real interest rate. The impact of changes in the REER is proportional to the openness of the economy, which is twice as large in each European country as in the US. However, as France and Germany trade with each other, the euro zone is exactly as open as the US. Uncovered interest parity is supposed to hold.
We consider two policy regimes in Europe, a floating exchange rate regime and EMU, and two alternative loss functions that represent the policymakers' preferences. In a first scenario, each country sets its monetary policy as to minimise a weighted average of square deviation from target of its inflation rate and its REER. We show that moving from floating exchange rate, our benchmark, to EMU, leads to an increase in the volatility of the real effective exchange rate of the US dollar. This result is due to the fact that the European Central Bank (ECB) internalises the intra-European policy externality: when France and Germany are hit by a symmetric, positive demand shock, each European partner raises its interest rate in order to dampen inflation and to limit the loss of competitiveness. As both countries implement the same policy, the intra-European exchange rate does not vary: ex post, the exchange rate channel of monetary policy is thus less effective than expected ex ante. On the contrary, with EMU, the ECB knows that the exchange rate channel of monetary policy is less effective. She then puts more emphasis on its internal objective of price stability and the US REER turns out to be more volatile.
The model also allows EMU and the ERM to be compared. We assume that within the ERM, the Bundesbank knows that the Bank of France will maintain the FF stable against the DM (fixed exchange rate equilibrium with leadership). In the case of macroeconomic shocks which hit both European countries symmetrically, the volatility of the US REER is the same within EMU and the ERM.
In order to check for the robustness of the above results, we examine a second scenario where the central banks' loss function includes consumer price inflation and the output gap (rather than the REER). The same increase in the volatility of the US REER is obtained when moving to EMU in the case of symmetric demand shocks. Again, the underlying mechanism involves the effectiveness of monetary policy with respect to its two targets. Within the floating regime, decentralised monetary policy in each European country over-estimates its impact on consumer prices. This is corrected by the ECB who puts more emphasis on the output gap, leading to more volatile European interest rates. The case of symmetric supply shocks is however different. As consumer prices and the output gap move in opposite directions (i.e. a rise in inflation and a decline in output in the case of an adverse shock), coordination failures result in an excessively tight monetary policy in Europe. Under EMU, the ECB does not underestimate the cost of curbing inflation in terms of output. The European interest rate become less volatile and so is the US REER.
Lastly, we introduce dynamics with a small three-country dynamic model which allows dynamic simulations to be performed. We obtain again that the US REER is more sensitive to macroeconomic symmetric shocks within EMU than with the floating regime. Yet, quantitative analysis of this increase of volatility shows that it should remain moderate. |
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