European Monetary Union
Stage Two in the 1980s?

Many have argued that a smooth transition to EMU requires coordination of the policies pursued in Stages Two and Three, when the European Central Bank may target monetary aggregates or use short-term interest rates to control inflation. But financial innovation may threaten both policies. The completion of the single market will accelerate the diffusion of financial innovation throughout Europe, which should learn from the experience of countries where it has already taken place, such as the UK and US. Many attribute the derailment of their `monetarist experiments' of the early 1980s to financial innovation, which weakened the existing relationships between financial and real variables.

In Discussion Paper No. 629, Research Fellow Michael Artis notes that financial deregulation and liberalization have made `currency substitution' possible and increasingly widespread, which suggests that monetary relationships should be more stable at the aggregate European than the national level. He analyses 1980s data for France, Germany, Italy, the UK and the US to determine whether there were discernible changes in the relationships between monetary aggregates and output or prices and to determine whether the links between the interest rate, output and prices remained stable when such changes occurred. His results indicate that M2 was the most robust aggregate across time and country; interest rate instruments under the authorities' control were both actively and reactively related to both monetary aggregates and to prices and output, while the feedbacks from interest rates to prices and to output tended to be more pervasive and more reliable than the corresponding feedbacks from money. Although there are important qualifications, these results do not bear out the common view that instability in the UK and US due to financial innovation portends instability in Europe: monetary relationships in these two economies proved more stable than expected.

Although relationships between monetary aggregates and prices and output did weaken over the 1980s, there were important exceptions: the relationships between M2 and real output in the US, and between M0 and both real output and prices in the UK, were stable; and financial innovation did not increase instability in France, which may be the leading indicator for Italy. The links between short-term interest rates and price and activity variables were generally strong and stable, but typically with long lags, which raises doubts about interest rates' suitability for `fine tuning'. Finally, aggregate European money demand was very stable and had the normal properties suggested by economic theory, which suggests that the prospects of success for monetary targeting in Europe are generally better than assumed a priori.

Monetary Policy in Stage Two of EMU: What Can We Learn from the 1980s?
Michael J Artis

Discussion Paper No. 629, January 1992 (IM)