Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : Lessons from the European Monetary System, August 15, 1987

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exchange-rate considerations. Because
of Germany's economic importance
within the European Community, the
other participant countries have had to
adjust their domestic policies or their
exchange rates to remain competitive in
international markets under the constraint of German monetary policy.
Nations participating in the ERM
arrangement often buy and sell foreign
currencies to defend their exchange
rates. Unfortunately, when such intervention is not supported by a change in a
nation's monetary policy, nor coordinated with the intervention activities of
other central banks, it only has a limited
influence on exchange rates. 8
The heavy intervention preceding the
January 12, 1987 realignment, for example, was mostly intramarginal and
generally was not accompanied by
changes in nations' monetary policies.
Germany, in particular, made only small
adjustments to monetary policy in response to the exchange-rate pressures.
Consequently, the intervention failed to
contain speculation , and a realignment
became unavoidable.
There are other problems. If a target
zone arrangement does not include all
major currencies, it may be vulnerable
to exchange-market pressures emanating from outside. On occasion,
exchange-rate stability in the ERM has

been compromised by exchange-rate
volatility of nonparticipating currencies
vis-a-vis the ERM currencies.
In particular, the Deutsche mark tends
to appreciate against other European
currencies when the dollar depreciates. 9
The January 1987 realignment in the
ERM, for example, was necessitated in
large part because the dollar's depreciation against the Deutsche mark caused
the mark to appreciate relative to the
other currencies in the ERM. Such realignments become necessary because
international investors do not hold all
ERM currencies in equal proportions in
their portfolios and because of economic
and financial differences among the
ERM countries.
To deal with this phenomenon, the
ERM countries need a common policy
response to external disturbances in
general and to the dollar in particular.
For example, an upward adjustment of
interest rates by the ERM countries,
except Germany, could have helped
divert part of the capital flows that
moved into Deutsche marks into other
ERM currencies.

8. See Deborah Danker, Richard A. Haas, Dale W.
Henderson, Steven A. Symansky and Ralph W.
Tryon, "Small Empirical models of Exchange
Market Intervention: Applications to Germany,
Japan, and Canada," Board of Governors of the
Federal Reserve System, Staff Studies 135, April
1985 and references.

9. See Francesco Gravazzi and Alberto Giovannini, "The EMS and the Dollar," Economic Policy,
No.2 (April 1986), Cambridge University Press,
London, pp. 455-484.

Federal Reserve Bank of Cleveland
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PO. Box 6387
Cleveland, OH 44101

Material may be reprinted provided that the
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Conclusion
As this brief review has suggested, the
success of any target-zone arrangement
for exchange rates depends on the ability of participant countries to agree on

many facets of policymaking and implementation. The slow progress of the
European community with respect to the
ERM and policy coordination, however,
exemplifies the difficulties of achieving
agreements on these many points. Implementing target zones on a wider scale
would be all the more difficult. Differences in preferences, policy objectives,
and economic structures account in part
for these difficulties.
More fundamentally, however, coordination of macroeconomic policies will
not necessarily benefit all participant
countries equally, and those that benefit
the most may not be willing to compensate those that benefit least. In the
ERM, Germany is less inflation-prone
than the other ERM countries and is
reluctant to cooperate at the risk of increasing its inflation rate. 10
Similarly, if benefits to the United
States from coordination of macroeconomic policies with the other industrial
countries are small, the United States
may be reluctant to relinquish its policy
independence, which is a necessary
condition for an effective coordination
of policies and for the maintenance of
target zones. Until the participant countries can agree on these issues, realignments of ERM currencies, and
worldwide exchange-rate fluctuations,
will be unavoidable.

.W
10. Actually, a recent study argued that policy
cooperation could introduce an inflation bias to the
EMS. See Kenneth Rogoff, "Can International
Monetary Policy Coordination be Counterproductive?" Journal of International Economics, May
1985, No. 3/4 pp. 199-218.

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August 15, 1987
ISSN 0428·127

ECONOMIC
COMMENTARY
Many economists and policy makers
have argued that the industrialized countries could minimize exchange-rate volatility and enhance economic stability if
West Germany, Japan, and the United
States linked their currencies in a targetzone arrangement.
Under a target-zone system, countries
adjust their national economic policies
to maintain their exchange rates within a
specific margin around agreed-upon,
fixed central exchange rates. Such a
system already exists for the major European currencies in the form of the
Exchange Rate Mechanism (ERM) of
the European Monetary System (EMS).
A review of the ERM provides valuable
lessons about the operations, costs, and
benefits of target-zone arrangements.
The European Monetary System began operating in March 1979. Its purpose is to foster monetary stability in the
European Economic Community, which
is a prerequisite for achieving the economic and monetary union of Europe.
All members of the European Economic
Community, except Portugal, have
signed the EMS Agreement, but Greece,
Great Britain and Spain have opted not
to participate in the Exchange Rate
Mechanism. 2
The ERM has gone through some
periods of strain and must still address
some difficult problems. Nevertheless,
it has not degenerated into a system of
frequent small exchange-rate adjustments, as some critics had forecast. On
the contrary, according to some analysts
the ERM has reduced the volatility of
both nominal and real exchange rates in
large part by fostering the convergence
of inflation and money growth rates
I

Nicholas V. Karamouzis is an assistant economic
advisor with the Bank of Greece and a visiting
scholar at the Federal Reserve Bank of Cleveland.
The author benefited from his participation in the
Foreign Exchange Group of Experts under the
Committee of the Central Banks of the Member
States of the European Economic Community. He

towards those of the best performer,
West Germany. J
This Economic Commentary discusses the exchange-rate mechanism of
the European Monetary System. The
first three sections describe the operation of the ERM. The final section highlights some problems facing the ERM
that are germane to the operation of any
target-zone system.
The Operating Components
of the ERM
The Exchange Rate Mechanism consists
of four major components: the European
Currency Unit, the parity grid, the divergence indicator, and the credit facilities. Because we are interested in the
exchange-rate management of the ERM,
we briefly discuss the European Currency Unit and then focus on the parity
grid and the divergence indicators.
The European Currency Unit (ECU)
is a composite currency, consisting of
fixed amounts of 10 European currencies.' The quantity of each country's
currency in the ECU reflects that country's relative economic strength in the
European community. The ECU functions as an unit of account, as a means of
settlement, and as a reserve asset for the
members of the ERM. Recently, it has
received growing use as a unit of account and as a means of payment in private transactions. Since the ECU is a
composite of many currencies, its exchange value is less prone to large
exchange-rate swings than are individual
currencies.
Three short-term credit mechanisms
enable one ERM member central bank to
borrow funds from another to finance

also thanks Gerald H. Anderson, Owen F Humpage, and Mark Snidermanfor their comments.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland, of the Board of Governors of
the Federal Reserve System, or of the Bank of
Greece.

Lessons from the
European Monetary
System
by Nicholas V. Karamouzis

exchange-market intervention. The Very
Short -Term financing facility provides
an unlimited amount of very short-term
credit to finance intervention at the compulsory intervention margins. The Mobilization Mechanism permits
temporary exchanges of official ECUs
for currencies, mainly to finance intramarginal intervention, or intervention to
influence exchange rates within the permissible bands. The Short-Term Monetary Support provides credits based on a
member's balance of payments and/or
the foreign-exchange reserve position.
The European Monetary Cooperation
Fund coordinates and facilitates all
transactions. Official ECUs serve as a
means of settlement in these transactions. Each central bank deposits at least
20 percent of their gold and dollar reserves with the European Monetary
Cooperation Fund in exchange for official ECUs.
The Parity Grid
Subject to the agreement of all the participants, each member of the exchangerate mechanism determines a central
exchange rate for its currency, which is
denominated in currency units per
ECUs. These central rates attempt to
establish equilibrium exchange values
for the currencies, but members can
seek adjustments to the central rates.
The ERM countries have adjusted the
central rates 11 times since the establishment of the EMS. With the most recent
realignment on January 12, 1987, the
ECU central rates have been: 42.4582
Belgian francs, 7.85212 Danish kroner,
2.05853 Deutsche marks, 6.90403
French francs, 2.31943 Dutch guilders,

I. See Owen F. Humpage and Nicholas Y. Karamouzis, "Target Zones for Exchange Rates?"
Economic Commentary, Federal Reserve Bank of
Cleveland, August I, 1986.

Table 1 Parity Grida
German~
+ 2.25

Central rate

·2.25
+ 2.25

DKr

Central rate
·2.25
+ 2.25

Irish pound

Central rate
-2.25
+ 2.25

Central rate
-2.25

.26810
.26216
.25630
2.740
2.678
2.619
.30495
.298164
.29150

Denmark
3.9016
3.81443
3.7300
1

10.451
10.2186
9.9913
1.1632
1.13732
1.1120

Ireland

France

.38182
.37328
.36496

3.4305
3.35386
3.2792

.10008
.09786
.09568

.89225
.87925
.85970

.11383
.111299
.108825

9.1890
8.9848
8.7850

2. Throughout this paper, ERM refers to countries
participating in the Exchange Rate Mechanism.
They are: Belgium-Luxembourg, Denmark,
France, the Federal Republic of Germany, Ireland,
Italy, and the Netherlands. EMS refers to countries
that are members of the European Monetary
System.

Chart 1 The Narrow Band on May 26,1987*
Percent
1.87%

a. All exchange rates are expressed in terms of national currencies rather than in terms of ECUs.
SOURCE: Author.

0.798411 Irish pounds and 1483.58 Italian liras.
These central rates establish a grid of
bilateral cross exchange rates among the
currencies. For example, 2.05853
Deutsche marks per ECU divided by
7.85212 Danish kroner per ECU equals
0.262162 marks per kroner, which also
implies 3.81443 kroners per mark (See
table 1).
Nations participating in the exchange-rate mechanism agree to keep
their currencies within a 2.25 percent
margin on either side of these central
cross exchange rates, except Italy which
has 6 percent margins. 5
Continuing our example, if the Danish kroner should strengthen against the
Deutsche mark and reach the upper intervention limit, the Bundesbank will
sell kroner to commercial banks at 3.73
kroners per mark, while Denmark's
National Bank will buy marks at 0.26810
kroners per mark.
It is rare for an exchange rate to move
from the lower band to the top band (4.5
percent) against a single currency. If the
Deutsche mark started strengthening
from the lower limit against the Danish
kroner, it probably would reach an upper
intervention limit against another currency before it reaches the upper limit
against the Danish kroner.
A convenient way to monitor the
relative position of each currency in the
band is to construct the so-called "narrow band of fluctuations." Usually the
narrow band shows the position of each

of the maximum possible movement.
When a currency crosses its "threshold
of divergence," the authorities of the
country concerned should implement
corrective policies.
On several occasions, however, the
d~vergence indicator has failed to proVIde an early warning signal. In part, the
widespread practice of intramarginal
intervention distorts the signal, but the
indicator also suffers from inherent technical problems. 7 The ERM members
need to modify the divergence indicator
and to develop new indicators that trigger consultation and policy responses
among the participants .

ERM currency relative to the weakest
currency in the group. It expresses the
weakest currency's market exchange
rate vis-a-vis each participant currency
as a percentage deviation from the weakest currency's central rate vis-a-vis each
participant currency.
Chart 1 shows the relative position of
ERM currencies against the Belgian
franc, on May 26, 1987. As the chart
indicates, the Danish kroner was the
strongest currency in the ERM on that
day, with the Danish kroner/Belgian
franc rate deviated 1.87 percent from the
Danish kroner/Belgian franc central
rate." All will lie within a band of 2.25
percent, except possibly the Italian lira.

The Divergence Indicator

Each member of the ERM must intervene when its currency reaches the 2.5
percent band against any other ERM
currency. Ideally, ERM members would
like to know when pressure is building
on their exchange rates, so that they
could take corrective action before their
exchange rates reach the 2.5 percent
bands. The divergence indicator attempts to provide such an early warning
signal.
Basically, the divergence indicator
measures the amount that an exchange
rate actually has moved from its central
rate, expressed as a percentage of the
maximum movement allowable under
the 2.5 percent bands. A "threshold of
di vergence" is established at 75 percent
3. See Horst Ungerer, Owen Evans, Thomas
Mayer and Philip Young. "The European Monetary
System: Recent Developments," IMF Occasional
Paper No. 48, December 1986.

The Functioning of the System

When a ERM currency diverges too far
from the central cross rates, appropriate
countries must introduce policies to
reduce the pressure on the exchange
rates. European policy makers generally
can employ three complimentary policies to deal with short-term pressures on
their exchange rates: 1) intramarginal
intervention, 2) fuller use of the
exchange-rate bands and intervention at
the compulsory margins, and 3) adjustment of interest rates.
Although experience varies, most
ERM countries adopt intramarginal intervention as the first line of defense.
Central banks of relevant countries undertake such intervention and usually do
not coordinate their activities with other
ERM central banks.
If market pressure persists, usually
the central banks of the "weak" currencies allow their exchange rates to move
closer to the lower boundary of the band
and/or adjust their domestic interest
rates upward. The aim is to penalize
speculators by making speculation
costly and less rewarding. If such policies do not stem the pressure on the exchange rate, or if the relevant countries
cannot implement the appropriate policies because of political or domestic
policy constraints, then EMS members
eventually will need to realign the central rates.

Belgian
Franc

Irish
Pound

D-Mark

SOURCE: Author.

Guilder

French
Franc

Kroner

"The Italian lira is not included.

The ERM provides valuable insights
into the operations of target-zone arrangements, and illustrates the problems
that such mechanisms are likely to encounter. Perhaps the most important
lesson that the ERM illustrates is that the

exchange-rate stability afforded by any
target-zone arrangement requires a coordination of economic-policy objectives.
Nations should achieve convergence of
those economic variables that directly
affect exchange rates, such as fiscal
deficits, current-account imbalances,
and real economic growth differentials.
Among the ERM countries, the fundamental nonmonetary determinants of
exchange rates are slowly converging.
Although monetary policies also have
become more similar, the participants do
not agree that zero inflation should be
the ultimate objective of the European
Economic Community. Consequently,
monetary authorities in the ERM countries often face a policy dilemma between exchange-rate stability and
interest-rate stability, and face a conflict
between domestic and external objectives.
The European experience has shown
that an aggressive interest-rate policy is
the most effective means of stabilizing
exchange rates, particularly when countries coordinate their policies. The need
for such coordinated policies has increased as EMS countries have lifted
restrictions on capital flows. Almost all
EMS countries have liberalized restrictions on capital flows related to commercial transactions and to long-term
financial transactions. Most countries
anticipate further liberalization of restrictions against short-term financial
flows in the near future.

As a result, small profit opportunities
will induce large capital movements
which, other things equal, will require
larger amounts of intervention to defend
the parities. The experience with the
January 12, 1987 realignment confirms
this view. In January, the volume of
speculative capital movements overwhelmed attempts to stabilize exchange
rates through intervention.
Exchange-rate stability requires that
interest-rate policies be coordinated and
geared towards maintaining exchangerate parities. But there are differences of
opinion among ERM members. Germany is reluctant to adjust interest rates
downward when the Deutsche mark is
under upward pressure, because it
claims that such actions could jeopardize domestic price stability. Similarly,
others are reluctant to increase interest
rates when their currencies depreciate
because they fear a detrimental impact
on their budget deficits and on their
domestic economic activity. A few
countries, like the Netherlands, allow
domestic interest rates to move widely
to contain exchange-rate pressures.
Economic convergence takes time; in
the meantime, realignments may be
unavoidable. If financial and real shocks
predominate over monetary shocks as
the major source of exchange-rate instability, policymakers will find it hard to
determine the need for and proper magnitude of an exchange-rate realignment.
Unfortunately, we have no precise meth-

4. For details about the ECU, see: The ECU,
European Documentation No. 6/84 (51pp.), European Community Information Service, Washington, D. C.

5. The figure ± 2.25 percent is only an approximation. To preserve symmetry, the actual limits are
2.27531 above, and 2.22469 below the central
rates.

6. This is calculated as follows: The Danish
kroner/Belgian franc market rate on May 26th was
0.18147651; the central cross rate was 0.1849376.
Subtracting the ratio: 0.18147651/0.1849376 from
one yields 0.0187 or 1.87 percent. In a similar way,
we can calculate the deviations of the other ERM
currencies from the Belgian franc.

Observations on the ERM

ods for relating economic variables to
exchange rates and, therefore, have no
precise way of determining the "equilibrium" value of exchange rates. At a
minimum, participating countries
should cooperate and develop methods
of monitoring economic developments
in order to identify at an early stage
possible signs of tension in the ERM.
Although some exchange-rate adjustment is unavoidable when national economic experiences conflict, the ERM
has no formal rules for determining the
timing and magnitude of realignments in
central rates. In the past, ERM countries
adjusted their central rates to offset differentials among their inflation rates.
This strategy implicitly provided a quantitati ve guide and a justification for
exchange-rate realignments. Now that
relative money growth rates and inflation rates within the ERM have become
more similar, realignments might be
smaller and less frequent than in the
past.
On the other hand, it could be harder
for the countries involved to agree on
new central rates. At the January 1987
realignment, for example, France and
Germany disagreed sharply over which
country's policies had caused the exchange problem and, consequently, on
which country should adjust and by how
much. The ERM countries eventually
agreed that the German mark would be
revalued, along with the Belgian franc
and the Dutch guilder.
Target-zone arrangements generally
specify in very broad terms that participants should adjust economic policies
when exchange rates threaten to break
through the bands. Typically, however, a
disproportionately large share of the
adjustment burden has fallen on the
"weak" currency countries.
Countries with appreciating currencies, trade surpluses and increases in
reserves are less prone to adjust than
countries with depreciating currencies,
trade deficits, or reserve losses. This
view is supported by the convergence of
inflation rates among the ERM countries. An equal sharing of the adjustment
burden implies that rates of inflation
among the participant countries would
converge to the average rate.
Germany, however, has maintained a
domestic monetary target of low or zero
inflation, and often has refused to alter
domestic monetary policy because of

7. See Roland Vaubel. "The Return to the New
European Monetary System Objectives, Incentives, Perspective," Carnegie Rochester Conference Series on Public Policy 13 (Autumn 1980),
pp. 173-221.