EMS
Dollar falls, tension rises

The dollar is now falling in value, after a five-year period of sharp appreciation. Yet its fall has not been uniform with respect to other currencies, and this may create pressure on the fixed parities of the European Monetary System (EMS). In Discussion Paper No. 97, Research Fellow Jacques Melitz analyses the difficulties which may arise within the EMS as the dollar depreciates. His analysis suggests that dollar depreciation may encourage EMS members to leave the system: membership may hold no advantage for them in this situation.

Melitz analyses the operation of the EMS in terms of a model of two countries, France and Germany. Each produces a different good which both consume. Capital is perfectly mobile between Germany and France in the model, and expectations in the exchange market are forward-looking. Melitz assumes that policy-makers in both France and Germany are concerned with the level of domestic output and the rate of inflation. Each country uses monetary policy to achieve its employment and inflation objectives through changes in the level of output and the exchange rate. The two countries also consume a third good, produced in the United States; movements in the value of the dollar therefore affect import prices and inflation in France and Germany. This is important because the two countries' policy preferences differ: the Germans are assumed to have a lower tolerance for inflation than the French. While the French are concerned to limit inflation to 'core' inflation, the Germans would like to reduce the rate of inflation to zero.

Melitz first considers the policy choices facing France and Germany during a period of dollar appreciation. Both Germany and France undergo inflation not only as a result of their own 'core' inflation, but also as a result of the rising price of US goods in terms of their own currencies. In the model Melitz assumes that the behaviour of the dollar is outside the control of France and Germany. The only other factor affecting their inflation rates are their bilateral terms of trade, which the two countries would like to manipulate in order to achieve their output and inflation objectives. The difficulty when the dollar appreciates is that both countries want an appreciation of their currency relative to the other, Germany more so than France.

Melitz examines the outcome of this in the absence of EMS policy coordination. Both countries attempt to appreciate their currency relative to the other in order to reduce the inflationary impact of the dollar appreciation. Germany wins the contest to reduce inflation because its desire to do so is stronger, but these efforts are counterproductive, as output in both countries falls. Melitz's analysis suggests that both countries will prefer exchange rate cooperation within the EMS when the dollar is appreciating. An EMS parity can be chosen which both countries prefer to the non-cooperative equilibrium, and there is no longer any attempt at competitive appreciation. One country will improve its output performance more than the other, with the distribution of these output changes depending on each country's policy preferences between output and inflation and on the realignment bargaining solution.

Melitz then considers the effects of a dollar depreciation on the EMS and finds that this poses more serious difficulties for the survival of the system. The depreciation of the dollar means that there is now downward pressure on inflation in France and Germany through import prices. This downward pressure, if sufficient, means that there is a non-cooperative equilibrium without the EMS in which France can reduce its inflation to its desired core rate at no output cost and another equilibrium if the pressure is even greater in which Germany can achieve zero inflation with no loss of output. In each case one country would clearly wish to leave the EMS. The system could only survive if the EMS parity were identical to that achieved in the non- cooperative equilibrium. But in this situation, Melitz argues, EMS membership holds no particular advantage for either country. This may lead policy-makers in both countries to conclude that their national interests call for an end to EMS membership.

The EMS could survive in these circumstances, but Melitz suggests several reasons why it might not do so. The survival of the system would require a return to the conditions of the European 'snake', placing either France or Germany in a position of dominance. It is not clear that this is politically feasible in the light of the evolution of the EMS since the Bremen agreement. Melitz points out that there are also economic costs to maintaining the EMS. If the French and German rates of inflation differ significantly, EMS stability may require the imposition of capital controls. If EMS membership conveys no positive economic advantages during a period of dollar depreciation, any such disadvantages may prompt policy-makers to reconsider their countries' membership.


The Prospect of a Depreciating Dollar and Possible Tension Inside the EMS
J Melitz

Discussion Paper No. 97, March 1986 (IM)