The ERM II issues: An interpretation of the Slovenian approach

This paper overviews the joint strategy of the Bank of Slovenia and of the Government of Slovenian for the policy management in the Exchange Rate Mechanism II (ERM II) and the eventual adoption of the euro. The current prospects of the Slovenian economy are favorable for early entry into ERM II so that the currency union can be acceded as soon as possible. The ERM II-connected risks, in particular an asymmetric credit financed demand boom, require a new policy mix to be set in place. While the monetary policy will focus on the tight management of the nominal exchange rate, the role of inflation restraint and shock absorption will rely on fiscal and income policies. The views expressed by the author do not necessarily correspond to those of the Board of the Bank of Slovenia. This paper was prepared for the panel “Monetary Policy and EMU Enlargement: The Adoption of the Euro” at the International Atlantic Economic Conference held in Lisbon in March 2004.     

Currency unions and trade: The special case of EMU

In this paper, the impact of the adoption of the euro on the commercial transactions of EMU countries is investigated. It seeks to disentangle the effects of eliminating exchange rate volatility — and those of other policy factors that promote integration — from the influence of the emergence of the European currency union. Since EMU is a relatively new phenomenon, a panel estimation of the gravity equation in a dynamic framework is used in order to capture effects like trade persistence. The main finding is that the adoption of the euro has had a positive but not an exorbitant impact on bilateral trade between European countries (ranging between 9 and 10 per cent). The impact is much lower than that shown in the recent literature on a larger and heterogeneous set of countries. One reason for this divergence seems to be that the euro was adopted after decades of integration policies had already worked through in Europe. JEL no. F4, F15, C230     

Adoption of the euro: Why is the Czech approach cautious?

When published, the Czech Euro-area Accession Strategy signalled a rather cautious approach to adopting the euro in comparison to the intentions of other EU acceding countries. The euro adoption was scheduled around 2010 and the ERM II was viewed only as a waiting room. The Czech strategy was attuned to specific features of the Czech economy. Although inflation and nominal interest rates converged to the EMU levels before EU entry, large fiscal deficits and the need for significant fiscal reform did not make it possible to meet the Maastrich criteria soon. Moreover, real convergence was viewed as a priority for the forthcoming years and, consequently, the strategy was aimed at maintaining nominal flexibility in order to cushion consequences of price and wage rigidities during the peak period of the catch-up process.     

Monetary policy towards E(M)U accession: A central banker's view

This paper gives a brief overview of the main economic issues related to the forthcoming integration of the new EU member countries into the euro area. Subsequently, it will discuss in more detail three broad issues concerning the monetary side of EU enlargement. First addressed is the timing of euro area enlargement and monetary policy regimes in the run up to the EMU. The next focus is on the ERM II as an interim step towards the euro area. Third, the author expresses his views on the future of the ECB and the euro area, which the Czech Republic will have an opportunity to co-determine after its entry. The paper is based on the author's Distinguished Address, as well as the symposium's panel discussion on the topic at the International Atlantic Economic Conference in Vienna, 14 March 2003.     

Misalignments of real exchange rates and the credibility of nominal currency bands

Misalignments of Real Exchange Rates and the Credibility of Nominal Currency Bands. — This paper analyzes a sticky-price target zone model in which realignment risk is modeled endogenously as a function of the degree of real exchange rate misalignments. The implications of the model are used to investigate the credibility of selected nominal ERM exchange rate bands. We find that a lack of credibility of the ERM currency bands occurs mostly in countries with substantial swings and persistent misalignments of real exchange rates. These findings suggest that the major real appreciations in some European bilateral real exchange rates between 1987 and 1992 have been pivotal in triggering the ERM currency crises of 1992 and 1993.     

Hong Kong's exchange rate regime:: Lessons from Singapore

Singapore's managed floating exchange rate regime contrasts with Hong Kong's currency board system featured by the Hong Kong–United States dollars peg. This paper appraises the two different exchange rate regimes by comparing their track records in maintaining macroeconomic stability and trade competitiveness in the 1990s. A review of the two regimes' institutional characteristics and macroeconomic performance reveals the systemic inadequacy of Hong Kong's exchange rate regime under a changing global financial environment. As East Asia emerges from the recent financial crisis, Singapore's experience of successfully moving away from a currency board system to a credible managed floating regime offers a lesson worthy of attention from Hong Kong.     

The Declining Impact of Exchange Rate Volatility on Trade

The introduction of the euro in 1999 eliminated exchange rate volatility between the members of the eurozone. Despite the elimination of currency risks, trade flows within the eurozone hardly increased (Bun and Klaassen in Oxf Bull Econ Stat 69:473–496, 2007, Santos Silva and Tenreyro, 2009). Using a standard gravity model, we find that nominal exchange rate volatility has had a negative effect on trade before 1985 but that this effect disappeared in later years, coinciding with the introduction and rapid diffusion of over-the-counter currency swaps. The estimated coefficient for the euro dummy does not change when we include nominal exchange rate volatility as an additional regressor. This confirms our finding that the impact of exchange rate volatility on trade has been small in more recent years.     

What the euro means for the dollar and the international Monetary system

This article begins by analyzing the hirtorical importance of the introduction of the euro, the convergence criteria for membership in the European Monetary Union, the merits and defects of the euro as an international rival to the dollar, and the characteristics that have made past international currencies great. It goes on to consider the institutional gap in the world system arising from the absence of an official world currency and the threat to stability that arises in transition periods when a new international reserve asset or currency is phased in. It is argued that the introduction of the euro will involve diversification from the dollar that will require multilateral attention to the dollar-euro exchange rate.Distinguished Address presented at the Forty-Fifth International Atlantic Economic Conference, Rome, Italy, March 14–21, 1998.     

Foreign Direct Investment in R&D and Exchange Rate Uncertainty

The current practice in the literature on the impact of exchange rate uncertainty on foreign direct investment is to consider exchange rate volatility. In this paper, we demonstrate the importance of considering also covariances and apply the theoretical arguments to a UK industry panel of FDI in R&D. An increase in the covariance of the euro and sterling, which would be a certain consequence of the UK’s entry into European Monetary Union, will increase foreign R&D into the UK. Increased volatility of the euro-dollar exchange rate tends to relocate R&D investment from the Euro Area into the UK.     

Business Cycle Synchronisation with(in) the Euro Area: in Search of a ‘Euro Effect’

This paper studies business cycle synchronisation and convergence in the euro area. A set of stylised facts concerning the characteristics of the business cycle and synchronisation in the euro area is derived. It is analysed whether convergence or divergence patterns between the euro area countries changed after the introduction of the euro. In addition, a closer look is taken at the degree of business cycle synchronisation between other, i.e. non-euro area countries and the euro area average. Furthermore, a dynamic correlation analysis is carried out to broaden the scope of business cycle synchronisation further. We enrich the study with a frequency domain analysis and use the concepts of coherence, dynamic correlation and phase. Our main results are (i) that the synchronisation of business cycles in the euro area is fairly high, and (ii) that the introduction of the euro in 1999 does not seem to have generated a very strong—neither positive nor negative—impact on synchronisation. Coherence and dynamic correlation among the euro area countries, the UK, Japan and the US are also fairly high, reminding of the importance of synchronisation with the global business cycle.     

Do international shocks affect small wholesalers and retailers?

Previous research has suggested that the smallest firms are those most vulnerable to international competition, as measured by exchange rate fluctuations and import shares. However, that work—and the overwhelming bulk of the empirical literature on determinants of exit or firm survival—dealt entirely with the manufacturing sector of the economy. This paper analyzes annual US data for 1989–2005 for about 50 wholesale and retail sectors to explain small firm exit rates in several employment size categories. The main result is that wholesalers respond negatively to a stronger currency in a manner similar to that of manufacturers, while retailers are generally unaffected.     

Optimal currency shares in international reserves: The impact of the euro and the prospects for the dollar

Foreign exchange reserve accumulation has risen dramatically in recent years. The introduction of the euro, greater liquidity in other major currencies, and the rising current account deficits and external debt of the United States have increased the pressure on central banks to diversify away from the US dollar. A major portfolio shift would significantly affect exchange rates and the status of the dollar as the dominant international currency. We develop a dynamic mean-variance optimization framework with portfolio rebalancing costs to estimate optimal portfolio weights among the main international currencies. Making various assumptions on expected currency returns and the variance–covariance structure, we assess how the euro has changed this allocation. We then perform simulations for the optimal currency allocations of four large emerging market countries (Brazil, Russia, India and China), adding constraints that reflect a central bank's desire to hold a sizable portion of its portfolio in the currencies of its peg, its foreign debt and its international trade. Our main results are: (i) The optimizer can match the large share of the US dollar in reserves, when the dollar is the reference (risk-free) currency. (ii) The optimum portfolios show a much lower weight for the euro than is observed. This suggests that the euro may already enjoy an enhanced role as an international reserve currency (“punching above its weight”). (iii) Growth in issuance of euro-denominated securities, a rise in euro zone trade with key emerging markets, and increased use of the euro as a currency peg, would all work towards raising the optimal euro shares, with the last factor being quantitatively the most important. J. Japanese Int. Economies 20 (4) (2006) 508–547.     

Credibility and Interest Rate Discretion in the ERM

Recent proposals for reforming the international monetary system often focus on a target zone arrangement for the dollar, euro and yen. Theoretical research suggests that a credible target zone confers on a participant some short-run discretion in the setting of interest rates, and recent empirical research suggests that this was indeed the case for the Classical gold standard, perhaps the best example of a credible target zone. In this paper we examine the extent of short-run interest rate discretion (SRID) conferred by another experiment with target zones, namely the ERM experience. Amongst our findings is the result that countries that had a credible commitment to the ERM did indeed have SRID.     

Testing the Unstable Middle and Two Corners Hypotheses About Exchange Rate Regimes

The recent rash of international currency crises has generated considerable interest in the role that exchange rate regimes have played in contributing to these crises. Many economists have argued that efforts to operate adjustably pegged exchange rate regimes have been a major contributor to “the unstable middle” hypothesis and some have argued that this unstable middle is so broad that only the two corners of hard fixes or floating rates will be stable in a world of high capital mobility—the two corners or bipolar hypothesis. Two recent empirical studies by researchers at the International Monetary Fund reach opposing conclusions on these issues. We examine the issue further and show that conclusions can be quite sensitive to how exchange rate regimes are grouped into categories and the measures of currency crises that are used. In general we find that the dead center of the adjustable peg is by far the most crisis prone broad type of exchange rate regimes, but that countries need not go all the way to freely floating rates or hard fixes to substantially reduce the risks of currency crises.

China's Exchange Rate Movements and Corporate Currency Invoicing Strategies

Since China introduced a new managed floating exchange rate regime in 2005, the persistent appreciation of the renminbi against the US dollar has led Chinese firms to reassess their choice of invoice currency among the dollar and other international alternatives to price their exports. The present paper performs a systematic invoice currency analysis by surveying the published literature, summarizing criteria for decision-making, and evaluating the choices available to Chinese exporters implementing currency invoicing strategies to maximize expected profits. This study finds that the euro could play an increasing role as the invoice currency of Chinese firms, although the US dollar will still play a dominant role. Chinese exporters might shift gradually from the dollar to the euro in the face of the falling dollar, balancing between the two by necessity.     

The euro and its consequences: What makes a currency strong?

The creation of the Economic and Monetary Union (EMU) and the introduction of the euro was one of the great events in economic history after World War II. The basic attractiveness of the euro is its large and expanding transaction size and the independent central bank which pursues price stability as its primary goal. The basic strength of the dollar is the hysteresis effect based on economies of scale and network externalities. The conclusion in the paper is that at present the hysteresis effect dominates the sheer size effect and the dollar remains the key vehicle currency while the euro has established itself as the second most widely used currency in the world. The euro depreciated against the dollar in the first three years after its introduction. In the paper the euro weakness is explained by the positive growth differential in favor of the U.S. economy caused by the advance in IC-technology and a pick-up in total factor productivity. In the medium run, the outlook for the euro is favorable. The U.S. current account deficit is unsustainable and improvements require a substantial depreciation of the dollar.Distinguished Address presented at the Fifty-Fourth International Atlantic Economic Conference, Washington D.C., October 10–13, 2002.     

Effect of exchange rate return on volatility spill-over across trading regions

This paper examines the effect of realized exchange rate returns on the volatility spill-over between the euro–US dollar and US dollar–yen currency pairs across the five trading regions: Asia, Asia–Europe overlap, Europe, Europe–America overlap and America. Modelling the interaction between returns and volatility in an autoregressive five-equation system, we find evidence that depreciation of the US dollar against the yen has a greater impact on the US dollar–yen volatility spill-over than appreciation in the subprime crisis period. Appreciation and depreciation of the US dollar against the euro does not appear to have an asymmetric effect on the euro–US dollar volatility spill-over. Our results support the notion that the yen may have been preferred to the euro as a ‘safe-haven’ currency relative to the US dollar during the subprime crisis period.     

Is Numérairology the Future of Monetary Economics?

The paper discusses some fundamental problems in monetary economics associated with the determination and role of the numéraire. The issues are introduced by formalising a proposal, attributed to Eisler, to remove the zero lower bound on nominal interest rates by unbundling the numéraire and medium of exchange/means of payment functions of money. The monetary authorities manage the exchange rate between the numéraire (‘sterling’) and the means of payment (‘drachma’). The short nominal interest rate on sterling bonds can then be used to target stability for the sterling price level. The paper puts question marks behind two key bits of conventional wisdom in contemporary monetary economics. The first is the assumption that the monetary authorities define and determine the numéraire used in private transactions. The second is the proposition that price stability in terms of that numéraire is the appropriate objective of monetary policy. The paper also discusses the merits of the next step following the decoupling of the numéraire from the currency: doing away with currency altogether—the cashless economy. Because the unit of account plays such a central role in New-Keynesian models with nominal rigidities, monetary economics needs to devote more attention to numérairology—the study of the individual and collective choice processes that govern the adoption of a unit of account and its role in economic behaviour.

Oil shocks and endogenous markups: results from an estimated euro area DSGE model

This paper estimates a linearised DSGE model for the euro area. The model is New Keynesian and allows for a role for oil usage and endogenous price markups. The importance of shocks to monetary policy and oil prices is estimated to have declined in the post-1990 period, in line with the higher predictability of policy and the fall in the persistence and—to a lesser extent—variability of oil disturbances. Counterfactual exercises show that oil efficiency gains would alleviate the inflationary and contractionary consequences of oil shocks, while higher wage flexibility would help ease the impact on real output at the expense of larger inflationary pressures. While we report evidence of “countercyclical” price markups, the rise in markups induced by an oil disturbance is not found to considerably amplify the inflationary and contractionary effects of the shock. The paper discusses the policy implications of our empirical results for the euro area economy.     

The Federal Reserve, the Bank of England, and the Rise of the Dollar as an International Currency, 1914–1939

This paper provides new evidence on the rise of the dollar as an international currency, focusing on its role in the conduct of trade and the provision of trade credit. We show that the shift to the dollar occurred much earlier than conventionally supposed: during and immediately after World War I. Not just market forces but also policy support—the Fed in its role as market maker—was important for the dollar’s overtaking of sterling as the leading international currency. On balance, this experience challenges the popular notion of international currency status as being determined mainly by market size. It suggests that the popular image of strongly increasing returns and pervasive network externalities leaving room for only one monetary technology is misleading.