Research Discussion Papers, Bank of Finland
Monetary Policy in the ERM: Internal Targets or External Constraints?
Abstract: This study is concerned with the determinants of monetary
policy in the ERM countries. We derive a monetary policy rule, an interest
rate rule, from a minimization problem faced by the central bank. The loss
function trades off costs of interest rate instability against benefits
from successful demand management and stable exchange rate in the ERM.
ERM-related considerations, particularly exogenous effects from German
interest rates as well as deviations from the ERM central rates, are
introduced into the analysis through the latter channel. In the empirical
section of the paper, we seek to quantify the significance of the effects
of the various factors on the domestic interest rate of the ERM-countries
by performing regression analysis with the domestic short-term interest
rate as the dependent variable. The evidence suggests that the countries
can be divided into two groups. In the first group (Belgium, Denmark,
France and the Netherlands) the exchange rate has deviated more from the
central rate since the widening of the fluctuation bands than it did
earlier. At the same time, the direct influence of German monetary policy
has diminished, while the significance of the lags of the domestic interest
rate has remained high or even increased. In the second group (Great
Britain, Italy and Spain) the trade-off in monetary policy has been more a
consideration of the two domestic factors than domestic and foreign
components of the loss function. These results seem to be consistent with
the interpretation that the EMS has become more symmetric, especially as
regards the "core" countries. One could also interpret the development of
the role of the EMS as a gradual introduction of an implicit coordination
mechanism through which countries have sought to improve interest rate
convergence by coordinating their policy targets. In this way, the role of
the ERM as a constraint on achieving policy targets has decreased.
Keywords: ERM; reaction function; exchange rates; monetary policy; (follow links to similar papers)
65 pages, April 14, 1997
Before downloading any of the electronic versions below
you should read our statement on
for viewing Postscript files and the
Acrobat Reader for viewing and printing pdf files.
Full text versions of the paper:
Questions (including download problems) about the papers in this series should be directed to Minna Nyman ()
Report other problems with accessing this service to Sune Karlsson ()
or Helena Lundin ().
Design by Joachim Ekebom