There is widespread agreement that German economic, monetary and social union requires a depreciation of the Deutschmark in the long run, so that increased net exports may finance Germany's growing foreign debt. In Discussion Paper No. 520, Research Fellow Jacques Mélitz assesses the implications of progress towards European monetary union for the value of the Deutschmark over time. If the other EMS member currencies follow the Deutschmark during the adjustment period, its depreciation vis-à-vis non-member currencies will increase with the proportion of the German trade deficit and German indebtedness that corresponds to the surpluses of countries outside the system. If Germany is already a member of a much larger monetary union when it returns to current account equilibrium, however, the whole union's external trade will be available to finance Germany's `extra-EC' debt, although this effect will be offset to the extent that monetary unification fosters intra-EC trade at the expense of external trade.

Mélitz notes that increased German demand for goods arising from reunification must be matched in the short run by increased net saving, which will require a rise in the German interest rate. If German monetary policy remains unchanged, the resulting appreciation of the Deutschmark will be offset in part by the fall in its expected long-run `fundamental' value, but the terms- of-trade adjustment will be slow enough for the short-run appreciation to prevail. This appreciation will be inversely related to the size of the fall in the fundamental value: it will therefore be greatest in a monetary union and lowest if the EMS continues with few realignments.

Mélitz argues for the close coordination of short- and long-run national policies within the EMS. If the pressures of German reunification lead to regular realignments, any short-run attempts by non-German members to resist them will merely amplify the Deutschmark's current appreciation vis-à-vis the dollar and pull the other EMS currencies out of line as well. But if there are to be no such realignments, policies should be coordinated to convince the public of this: otherwise other currencies' short-run tendencies to follow the Deutschmark will aggravate upward pressures on all EMS currencies.

Once the market views the Community as a single-currency area, its future adjustment to German reunification will seem a smaller problem, and this will amplify the Deutschmark's short-run tendency to rise in response to demand shocks. This problem will be mitigated in practice by the Deutschmark's probable undervaluation for the 3-4 years before reunification, as its current account surpluses of 4% of GNP suggest, so the shock of reunification probably brought the fundamentals and the current price back into line.

German Reunification and Exchange Rate Policy in the EMS
Jacques Mélitz

Discussion Paper No. 520, February 1991 (IM)