Policy Coordination in the European Monetary System : Occa Paper 61

International Monetary Fund

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1988
• eBook ISBN: 9781557750280

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Part I The European Monetary System: A Balance Between Rules and Discretion

I Introduction

Over the last four decades, one area that has evolved rapidly in the international economy, albeit not without periodic setbacks, has been the domain of economic interdependence. As noted by Cooper (1968) early on,¹ the increasingly close linkages that interdependence has prompted among national economies can either enhance or constrain their ability to pursue domestic objectives. From this vantage point, adaptation to economic interdependence can thus be described as a process that requires a demarcation of the boundaries of national freedom, an endeavor in which it is often useful to distinguish between systems based mainly on rules and regimes that lean instead on discretionary action.² The issues involved in the process of demarcation and the distinction between the two types of systems are not exclusive to international economic relations, and examples of similar issues are numerous in other forms of country interactions. But the requirements of the process in most, if not all, areas call for the development of commonly agreed norms by reference to which the outer limits to individual country freedom can be established.

As the postwar evolution of the international economy clearly illustrates, the process of interaction among national economies is dynamic and ever changing. It is not surprising, therefore, to observe that norms of international behavior evolve with (and are influenced by) circumstances and that their scope varies with the global environment as it moves from situations of relative harmony to situations where tensions predominate.

Regardless of the particular international behavioral norms in place at a particular time, no economy operates in isolation. As a result, countries constantly face the need to balance their natural desire for autonomy with the limits set by the interdependence of the international system. National attitudes toward the attainment of such a balance will depend on the relative weight each country gives to internal and external considerations. These attitudes also vary over time, and in the process, they set the international economy on courses that alternate between cohesion and divergence. These general observations apply to the international economy at large, but they are also representative of developments in Europe. In particular, they can be used to describe the quest for European monetary integration, of which the European Monetary System (EMS) represents the most advanced stage attained so far.

The purpose of this paper is to provide a survey of the process of European monetary integration, with particular focus on the EMS, its purposes, evolution, and the experience gathered since its establishment in early 1979.³ After this introductory section, the paper is structured along the following lines: Section II summarizes the broad criteria advanced in the literature to guide the choice of the scope of monetary regime and the type of exchange rate system. Section III reviews briefly the attempts at monetary integration made in Europe that anteceded the EMS. Section IV summarizes the objectives and main characteristics of the EMS as well as the prospects initially envisaged for the system. Section V draws inferences from developments to date within the EMS; to this end, after examining a few general issues related to the assessment of economic performance, this section reviews the experience gathered under the system. The section also surveys previous analyses of the performance of the EMS from three vantage points: exchange rate variability; economic policy coordination; and convergence of economic performance. On this basis, a discussion follows on the degree of cohesion among participating countries that has been developed within the EMS. Against this broad background, Section VI examines the considerations surrounding the issue of participation in the EMS. Finally, Section VII draws together some concluding remarks concerning the balance attained in the system between rules and discretion and the consequent implications for the participants.

II Criteria for Choice of Monetary and Exchange Regime

The efforts toward monetary integration in Europe did much to renew and keep alive general interest on such issues as the choice of exchange rate regime, the appropriate scope of currency areas, and their implications for participating countries as well as for the rest of the world.⁴ The exchange rate and balance of payments implications of monetary integration have been examined at length in the literature from a variety of perspectives. But the impetus for the research on issues concerning monetary zones was provided by an early and classic article by Mundell (1961), which introduced the concept of “optimum currency areas” and analyzed its implications.

In general, the examination of the requirements of currency areas can follow two different—but related—approaches: one that focuses on the conditions that would be needed or desirable for a single economy to have in order to participate in a monetary zone; and another that centers on the costs and benefits of such participation.

Necessary Conditions Approach

This approach seeks to establish criteria to ascertain the circumstances under which an economy that forms part of a currency area is thereby in a better position to attain its basic economic policy objectives (e.g., full employment, price stability, and external balance). The criteria that are typically put forth can be classified under two broad headings: criteria that may be labeled objective, which point to specific features of the economy; and criteria that could be instead called subjective, which point to the preferences and choices of agents in the economy.

The identification of objective criteria begins with the above-mentioned article by Mundell. In his analysis, Mundell stresses the existence of a high degree of mobility of factors of production as critical for the efficiency of a currency area. In a sense, this criterion postulates a large measure of openness in the economies that constitute the monetary zone, as far as the markets for factors of production are concerned. This principle of openness has been suggested explicitly by McKinnon (1963) as an essential feature of economies within a currency area. In McKinnon’s analysis, openness is measured by the ratio of tradable to nontradable commodities, so the focus is thus placed on the market for goods and services.⁵ A variant of McKinnon’s criterion that, in common with it, focuses on the composition of output and on the commodities market has also been advocated by Kenen (1969). Specifically, Kenen argues that the degree of diversity of the product mix in an economy is another important consideration in the determination of the domain of a currency area. A fourth objective criterion that has been proposed is the degree of financial integration that binds together the economies in a currency area. This criterion shifts the focus from the goods to the capital markets and can be seen as a specific modality of Mundell’s principle of factor mobility.⁶

Criteria of a character identified above as subjective have also been postulated to determine the appropriate scope of a currency area. They fall basically into two categories that focus, respectively, on the commonality of aims and on the similarity of policy attitudes. Thus, the prevalence of broadly equivalent rates of inflation or the existence of similar inflation-output or inflation-employment trade-offs are often cited as necessary conditions for participants in a monetary zone. Alternatively, a principle of pol...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Prefatory Note
• PART I The European Monetary System: A Balance Between Rules and Discretion
• PART II Monetary Policy Coordination Within the European Monetary System: Is There a Rule?
• Footnotes