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Exchange Rate Policy Options of the European Central Bank

by Markus Bruetsch (Author) Mark Davis (Author) Alexander Dalhoff (Author) Sven Hansen (Author)

Essay 2003 22 Pages

Business economics - Banking, Stock Exchanges, Insurance, Accounting

Excerpt

Table of Contents

I. Executive summary
1. Introduction
2. Development of the euro since
2.1 The path of the euro
2.2 Explanations of the weakness of the euro
3. Exchange rate policy-making in the EMU
3.1 Floating exchange rates
3.2 Managed floating exchange rates
3.3 Fixed Exchange rates
3.4 Fixed Rates with Bands
4. Keynes vs. Neoclassic – Market interventions
4.1 Options for market intervention
5. Recommendation for a future exchange rate policy

II. Bibliography

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.

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.

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.

illustration not visible in this excerpt

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 mainly settled in dollars, this has increased demand for the currency around the world. Exchange-rate models taking explicit account of the oil price as an explanatory variable do indeed show oil price increases exerting downward pressure on the euros exchange rate.

The differences between the USA and Europe in their economic dynamism are often interpreted to imply that the American economic system is superior to that of the euro zone, whether due to lower levels of regulation or due to the US lead in what are considered the technologies of the future. Until the euro was introduced in 1999, the exchange rate of the ECU to the US dollar was readily explicable in terms of major fundamental factors such as price and interest-rate differentials. However, the subsequent movement of the euro/dollar exchange rate has been much less favorable than would have been expected on the basis of those fundamental factors, so other factors have evidently come into play. A body of evidence suggests that, as European Monetary Union was put into practice and the integration project moved a step further, a new, qualitative aspect has emerged in the assessment of the common currency zone’s performance and potential, and equally of the new currency itself, the euro.

When the new monetary union came into being at the start of 1999, the emphasis was on the increased significance of the corresponding economic zone, given its economic muscle and its prominent position on world markets. This was taken to indicate that the EMU economies were highly competitive. On the other hand, the drop in the euros value since its launch is said by many to reflect a poor competitive position.

The euros performance is normally judged against its exchange rate at the time European Monetary Union (EMU) entered its final stage at the start of 1999 and there is no denying that the euros external value has dropped substantially on that basis.

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Details

Pages
22
Year
2003
ISBN (eBook)
9783638201469
File size
506 KB
Language
English
Catalog Number
v14848
Institution / College
Oxford Brookes University – Business School
Grade
1,4 (A)
Tags
Exchange Rate Policy Options European Central Bank International Investment Finance

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Title: Exchange Rate Policy Options of the European Central Bank