German Unification
Monetary union

German monetary union on 1 July 1990 introduced a modern financial system into East Germany together with a stable, convertible and high-reputation currency. The Bundesbank conducted monetary policy for an enlarged currency area and under increased uncertainty, since little was known about the portfolio choices East Germans would make or the actual money demand (and hence the appropriate money supply), and there were no accurate data on the levels of real output or prices.

In Discussion Paper No. 719, Research Fellow Jürgen von Hagen reviews the main monetary trends in Germany during 1989-91 to show that the volatility of velocity shocks increased in the quarters following monetary union, that the stability of the money demand function must be rejected for the broad monetary aggregate M3 but may be accepted for M1, and that the uncertainty inherent in monetary control after the union was not significantly greater than before. Monetary targeting therefore remained an appropriate strategy to achieve price stability, but the greater stability of M1 implies that a narrow money target would have been preferable, while the increased variance of the transitory shocks suggests that the Bundesbank should have reduced its responses to short-run changes. Von Hagen also finds that there was an acceleration in the equilibrium price level even before union due to the monetary expansion in late 1989, followed by a fall in early 1991 and a period of stability thereafter. A further price level adjustment must be expected in 1992 and in part of 1993.

Von Hagen concludes that a reorientation of monetary strategy would have been desirable after July 1990, but its general approach remained appropriate. On this evidence, Central and East European countries should target a transactions-oriented monetary aggregate rather than an exchange rate peg to achieve monetary stability, while a future European monetary union should target European transactions-oriented money stock rather than a broad aggregate.

Monetary Union, Money Demand and Money Supply: A Review of the German Monetary Union
Jürgen von Hagen

Discussion Paper No. 719, October 1992 (IM)