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The article focuses on the creation of a system for monetary stability in Europe. The article also discusses the contribution of the European Monetary System (EMS) to the reduction of the exchange rate volatility and the importance of capital controls for the increased volatility of interest rate differentials. It is explained in the article that the goal behind the foundation of the European Monetary System (EMS) in March 1979 was the creation of a system of monetary stability in Europe. The adoption of the EMS is attributed to the reduction of the intra-EMS nominal and real (bilateral and effective) exchange rate volatility relative to the pre-EMS period.

This paper investigates the long-run and short-run relationship between deposit euroization in twelve European post-transition economies and two determinants of deposit euroization that are under the influence of monetary policy: the exchange rate and the interest rate differential. The link between deposit euroization, exchange rates and interest rate differentials is investigated using Johansen cointegration and error correction models for each country separately. The results suggest that changes in both monetary drivers have significant effects on deposit euroization and are therefore important for explaining and fighting deposit euroization. Differences between exchange rate regimes, fixed and managed vs. floating, seem to matter for deposit euroization. [ABSTRACT FROM AUTHOR]

The appetite for fiscal discipline has been steadily declining among most industrial countries. In the past, fiscal profligacy would have been punished by markets with higher interest rates and, in some cases, also exchange rate depreciation. However, in post-EMU Europe, exchange rate markets no longer discipline the fiscal behaviour of national governments. Perhaps more crucially, even the interest rate punishment to fiscal indiscipline is highly uncertain, with academic opinions being quite divided on this issue. This paper takes a close look at the link between fiscal policy and interest rates in the European context. The key finding is that an expansionary fiscal policy in one EMU member will have an effect both on its spreads and on the overall level of interest rates for the currency union as a whole, with the second effect, however, being quantitatively much more significant. This suggests that there are indeed substantial spillovers, through the interest rate channel, among fiscal policies of member countries. To limit countries' incentive to run expansionary fiscal policies, a set of rules, like those embedded in the Stability and Growth Pact, is then needed. Some (weak) evidence is also found that after EMU, interest rate spillovers seem to be more significant for high debt countries with unsustainable fiscal policies, reflecting perhaps market concerns about a possible sovereign bail out or the impact of financial distress. There may be a case then for imposing tighter rules on high debt countries. [ABSTRACT FROM AUTHOR]

This article examines the new consensus that fiscal policy should have no macroeconomic role in 'flexible inflation targeting' regimes. There is little basis for this presumption. Fiscal policy remains important in setting the policy mix and in managing shocks and imbalances. The credibility of an inflation-targeting regime should be enhanced rather than reduced if fiscal policy plays its proper role. It is true, nevertheless, that the costs of focusing fiscal policy narrowly on public-sector concerns may not be very great, most of the time. However, when interest rates cannot be used, the role of fiscal policy must be different. With interest rates at their lower bound of zero, there is no plausible alternative. For asymmetric shocks and adjustments in EMU, fiscal policy needs, ideally, to substitute for the interest-rate policy reaction function of the consensus, but the difficulties are very great. We suggest a policy focus on real exchange rates as a way of resolving some of the dilemmas. There is a serious danger that orthodox views about fiscal policy, drawn from the consensus, will be inappropriately applied, especially in Europe. [ABSTRACT FROM AUTHOR]

Empirical work on uncertainty and investment generally focuses on one country or one indicator of uncertainty. We extend the literature by assessing the impact of a comprehensive range of potential sources of uncertainty on aggregate business investment across the G7 using Pooled Mean Group Estimation (PMGE) and GARCH methods to model uncertainty. A significant negative long-run effect from exchange rate volatility is found for the G7 and in poolable subgroups including all four larger EU countries. Volatility of long-term interest rates has additionally influenced investment in recent years. For most estimates, a one standard deviation rise in conditional volatility leads to a 2-4 per cent fall in investment although some samples give greater declines. The results suggest inter alia that EMU is beneficial to aggregate investment, JEL no. E22, F31 [ABSTRACT FROM AUTHOR]

We show that within Bertola and Svensson's second-generation target zone model, mean-reverting interventions and endogenous devaluation risk are closely interrelated. Over the period 1983-93 we analyze the degree of mean reversion in the underlying fundamental process as well as the term structure of interest rate differentials vis-a-vis Germany for six Exchange Rate Mechanism currencies. For Austria, Denmark and the Netherlands, and for Belgium after 1990 our estimates are broadly in line with the first-generation target zone model, whereas those for France and Italy are in accordance with the model that allows for endogenous devaluation risk. (JEL F31, E43) [ABSTRACT FROM AUTHOR]

In the early hours of August 1, 1993, weary European Monetary System (EMS) officials reluctantly adopted the deep bands of fluctuations around unchanged central parities. The new bands avoided a complete breakdown, possibly a fatal blow to the wider objective of a single currency. The official communiqué implied that the temporary widening of the margins of fluctuations was a tactical retreat in the face of a year-long series of attacks. Soon afterwards, though, a new, more upbeat view, emerged, presenting the deep bands as the definitive solution to increased financial-market instability. This article looks into the actual behavior of the new EMS as revealed by daily exchange-rate data. The estimates indicate that the new deep bands adopted in 1993 conceal the adoption of narrower bands, which are typically not centered around the official parity. The current system has a number of advantages, which are contrary to the spirit of the old EMS. First, the bands may be moved at the authorities' discretion. Authorities no longer offer one-way bets to speculators. The cost of frequently changing the bands is a loss of credibility and possibly higher volatility in the interest rate or a higher exchange-rate premium. Second, contrasting with the countries, which suspended participation to exchange-rate mechanism of the EMS, the system of deep bands has exerted a stabilizing effect on exchange rates.

This paper examines currency substitution (CS) and the incentive for European monetary union. In the standard money demand study, interest rates are entered as the opportunity cost of holding money. Thus, if foreign interest rates enter significantly in a standard money demand function, this is interpreted as evidence of CS. Since money services may be provided by either domestic or foreign money, the domestic money demand function includes both domestic and foreign variables. With no CS, the standard floating exchange rate scenario is one of a stable money demand function for each currency that is independent of external nominal shocks. Since the issue of CS is relevant for policy under floating exchange rates, the money demand functions will be estimated over the 1973-80 period. The key variables for testing the hypothesis of CS are the money quality or inflation uncertainty variables. Foreign money yields a pecuniary return only because of exchange rate changes. The money quality proxies suggest that there is substitutability between the pound and the franc in the British regression, the mark and all three foreign alternatives in the German regression, and the lira and the franc and mark in the Italian regression.

The primary objective of the paper is to establish that international portfolio capital flows are sensitive to changes in the international constellation of real interest rates. In calculating those real interest rates, the study emphasizes inflationary expectations operating through exchange rate expectations. The U.S. real rate enters every country's demand for foreign assets equation, consistent with the expectation that most foreign portfolio holdings are dominated by the U.S. liabilities and are correspondingly sensitive to changes in the U.S. real yields. The counterpart to this last observation is the significance of the U.S. real rate in the U.S. equation for liabilities to foreigners. All asset equations include the domestic rate as significant, indicating the sensitivity of domestic investors to the return on domestic assets. The adjustment speeds in the liability equations tend to be higher than those in the asset equations. This observation may reflect subtle difference in the substitution processes being modeled on the asset and liability sides.

In the spectrum of alternatives that includes both flexible and fixed exchange rates, currency areas and monetary unions both fall into the general category of fixed exchange rates. But whereas a currency area involves two or more currencies fixed to one another, a monetary union implies an agreement to share a common currency. A distinction between "true" and "pseudo" currency areas may be useful. The former is applied to systems like bimetallism and the gold standard which contained an automatic adjustment and a commitment to stability that, in times of peace, was virtually absolute. The Bretton Woods arrangements and also the Exchange Rate Mechanism of the European Monetary System, however, are better characterized as pseudo currency areas, insofar as countries do not allow the automatic adjustment mechanism to operate and parities can be changed relatively easily by ministerial decisions. Under a true currency area, interest rates tend to converge, and speculation is stabilizing; but under a pseudo currency area, interest rates diverge by an extent determined by expected exchange-rate changes, and speculation, based typically on a one-way option, is destabilizing.

Investigates the status of capital markets in Europe. Hike in interest rates; Development of a unified European capital market that could raise funds for the continent's economies; Devices created for protection against fluctuating exchange rates.

Different European countries pay very different interest rates on their public debts. Will these differences disappear if and when exchange rates come to be irrevocably fixed in the European Monetary Union? Or rather will default risks in the high debt countries keep interest rates from converging? To answer this question, this paper investigates whether a perceived default risk is already priced by the market. The paper compares the interest rates on public and private financial instruments denominated in the same currencies in 12 OECD countries. A strong correlation is found between the size of public indebtedness and the spread between public and private rates of return. This correlation suggests that the markets perceive a default risk on the public debt of some OECD countries. The size of this default risk is however very small. [ABSTRACT FROM AUTHOR]