The Delors Report envisages Stage Two of EMU as a transitional period, during which national monetary authorities will retain ultimate responsibility for policy, although the functions of the European Monetary Institute will increase as it coordinates these policies in accordance with guidelines set at the Community level. In Discussion Paper No. 616, Research Affiliate Michael Moore and Thomas O'Connell consider possible guidelines for national monetary authorities during Stage Two. They first argue that the central bank's balance sheet is an inadequate measure of a country's monetary policy stance, since it takes no account of the monetary implications of Treasury operations. If a small open economy operates a fixed (or quasi-fixed) exchange rate and runs a large public deficit, adopting such an ex post measure of its monetary stance will enable it to use foreign reserves to adjust its money stock to money demand. If it uses ex ante indicators instead, however, such foreign exchange interventions may represent the central bank's response to excessive domestic money creation.

Moore and O'Connell review the experience of several EMS countries since December 1978. The domestic (and foreign) assets on central bank balance sheets have increased gradually and modestly during this period, but there have also been a high rate of domestic high-powered money creation (due to the monetization of government foreign borrowing) and significant pressure on the foreign exchange markets. In Belgium, Denmark and Ireland, the central banks' domestic assets have scarcely grown since 1979, but the stocks of direct government foreign debt has grown dramatically. The distinction between central banks and Treasuries is purely institutional, and attention should focus on the two institutions' consolidated balance sheet, taking account of the Treasury's direct and indirect foreign borrowing.

Moore and O'Connell use the insights from the monetary approach to the balance of payments to derive a long-run relation between domestic credit and a composite measure of `exchange market pressure'. While previous analyses of this relationship have focused on percentage first differences, they examine the long- run relationship between exchange market pressure and the levels of explanatory variables. They apply this procedure to Belgium, Denmark, Ireland and Italy, with the Deutschmark as the reserve currency in all cases, and their results broadly confirm their theoretical reasoning. They therefore conclude that national monetary policies during Stage Two should take account of the potentially destabilizing effects of Treasury operations.

Monetary Policy in Stage Two of EMU
Michael J Moore and Thomas O'Connell

Discussion Paper No. 616, January 1992 (IM)