Exchange Rates
New lessons

The currency crises in the ERM and the Nordic countries of 1992-3 have called into question the role of fixed exchange rates in achieving price stability. In Discussion Paper No. 872, Research Fellow Lars Svensson reviews the events leading to the August 1993 widening of the ERM bands and discusses the contributions to the crises of: increased capital mobility and the growth of foreign exchange markets; real exchange rate divergence resulting from weak monetary and fiscal policies in some countries and asymmetric real shocks; self-fulfilling speculative attacks the inefficiency of large-scale sterilized central bank intervention under the ERM rules; and the conflict of non-sterilized intervention by the Bundesbank with domestic price stability.

Svensson shows that time-series of interest rate differentials indicate that most market participants did not anticipate the September 1992 crisis until well into August, except in Italy where devaluation expectations increased following the Danish referendum in June. He concludes that maintaining fixed exchange rates is much more difficult than was previously thought, and even if maintained they can conflict with price stability or induce procyclical destabilizing monetary policy. With an `imported' nominal interest rate, a boom can raise inflation which reduces the real interest rate and reinforces the boom, so revaluation expectations force down the nominal interest rate and monetary policy becomes even more expansionary.

Fixed exchange rates therefore provide no short-cut to price stability. Monetary stability and credibility must instead be built at home, through institutional reform based on granting the central bank independence and holding it accountable for maintaining price stability. The pursuit of a fiscal policy consistent with price stability and reform of the wage-setting process to allow full employment at the same time requires the building of political support, which becomes even more critical after a shift to flexible exchange rates. Svensson concludes that fixed exchange rates can sometimes complement but never substitute for domestic monetary stability and credibility; they are neither necessary nor sufficient to achieve of price stability.

Fixed Exchange Rates as a Means to Price Stability: What Have We Learned?
Lars E O Svensson

Discussion Paper No. 872, January 1994 (IM)