The recent period of floating exchange rates has been characterized by extreme real and nominal volatility of the major currencies, which is often contrasted with the experience of the European Monetary System (EMS), which is cited as an example of the benefits conferred by a system of managed currencies. While it is often claimed that the EMS has exerted a short-run stabilizing effect on intra-EMS rates, both real and nominal, studies of the resulting welfare gains and of the effects on trade are less certain. It seems likely that long-run volatility i.e. the tendency for fundamental misalignments to arise within a group of exchange rates will be of greater significance for welfare, and that the achievement of real exchange rate convergence will require the convergence of monetary policies.

In Discussion Paper No. 444, Ronald MacDonald and Research Fellow Mark Taylor seek to measure and compare the convergence of real and nominal exchange rates and of monetary policy among EMS members and non-members alike through an application of the multivariate cointegration technique proposed by Johansen. They study the bilateral US dollar nominal and real exchange rates for the French franc, Deutschmark and lira, and for the Canadian dollar, yen and sterling, for a period from the inception of the ERM in March 1979 to December 1988, and also the nominal money supplies for all these currencies. They find evidence of long-run convergence of nominal and real exchange rates, as well as money supplies, for the three EMS member countries, but not for the others. Long-run stabilization of both nominal and real exchange rates requires long-run policy convergence, which is apparent from the cointegration of the EMS members' money supplies.

This raises the issue of the emergence of one or more EMS members as policy-leaders over the period, and in particular the anecdotal evidence to suggest that Germany is the dominant player, setting its monetary policy largely autonomously while other ERM members have attempted to converge on the German standard. MacDonald and Taylor examine the `German leadership hypothesis' by drawing on the previous econometric analysis and testing for `Granger causality' of two series moving together, which must run in at least one direction between them. Their results reveal strong evidence in favour of the German leadership hypothesis, with Granger causality running from the Deutschmark to the other EMS currencies, but no causality between other currencies. Indeed even lagged values of the French money supply are jointly insignificant in explaining its current value, and this finding broadly accords with the evidence that foreign exchange intervention to support intra-EMS parities is predominantly undertaken by non-German members and that intervention is systematically sterilized in Germany but much less commonly in other EMS countries.

Exchange Rates, Policy Convergence and the European Monetary System
Ronald MacDonald and Mark P Taylor

Discussion Paper No. 444, September 1990 (IM)