EXCHANGE RATES AND MONETARY POLICY VI´TOR GASPAR and OTMAR ISSING1 European Central Bank This paper looks at the relation between exchange rates and monetary policy. It focuses in particular on the role of the exchange rate of the euro in the context of the ECB’s monetary policy strategy. The objective of monetary policy is to maintain price stability. The euro area is a large and relatively closed economy. Therefore, the exchange rate of the euro is not an intermediate target nor is it an objective. Nevertheless, the ECB’s stability-oriented monetary policy strategy does not neglect the exchange rate of the euro. Clearly, exchange rate developments are taken into account both when looking at the transmission mechanism of monetary policy and when assessing the current economic situation and prospects for the euro area.

I.

Introduction

The exchange rate of the euro has motivated a great deal of attention since its start in January 1999. A lot of ink has been devoted to the depreciation of the external value of the euro after its launch. Even before the start of Stage three of Economic and Monetary Union (EMU) a debate was going on concerning the implications on the euro exchange rate associated with the transformation of the European financial system and the international role of the euro. This paper looks at the relation between exchange rates and monetary policy. In particular it focuses on the role of the exchange rate of the euro, in the context of the ECB’s monetary policy strategy. The European Central Bank (ECB) announced the stability-oriented monetary policy strategy on October 13, 1998 (ECB, 1998).The strategy includes three main elements: first and foremost a precise definition of price stability. Price stability has been defined as an annual increase in the Harmonised Index of Consumer Prices (HICP2) of below 2 per cent. Price stability is to be maintained over the medium term. The definition clearly signals the ECB’s commitment to maintaining price stability. Price stability is stated as the ECB’s primary goal in its Statute and the European Union Treaty (EUT). Second, analyses based on models and indicators assigning a prominent role to money (under the label first pillar of the strategy). The prominent role of money in the strategy is signalled by the announcement of a reference value for the growth of a broad monetary aggregate (M3). Third, analyses based on a wide range of other models and indicators (under the label second pillar of the strategy). The Correspondence: Central European Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany. Email: [email protected]. 1 EUROPEAN CENTRAL BANK. The views expressed are the authors’ own and do not necessarily reflect those of the ECB or the Eurosystem. We would like to thank Carsten Detken, Lutz Kilian, Klaus Masuch, Chiara Osbat, Frank Smets, Berndt Schnatz, Jerome Stein, Oreste Tristani and an anonymous referee for helpful comments. Sandrine Courvoisier for producing the tables and charts and Patricia Kearns-Endres for administrative assistance. The responsibility for the remaining errors is our own. 2 The HICP is released monthly by Eurostat, the statistical office of the European Union. See Astin (1999).
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Table I

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Key features of euro area member countries (2000, in % of GDP, unless otherwise stated) Area

BE

D

E

F

IRL

Population (mn) 304.3 10.2 82.2 39.5 60.6 3.8 GDP (share of 16.0 0.6 4.6 1.8 3.2 0.2 world GDP, %) GDP per capita 21.5 24.2 24.6 15.4 23.2 27.3 (EUR thousand) Sectors of productiona Agriculture, fishing, 2.4 1.4 1.2 3.5 2.8 3.8 forestry Industry (including constr.) 28.5 26.6 30.3 29.2 25.4 36.0 Services 69.1 72.0 68.5 67.3 71.7 60.2 Exports of goods 19.7 86.3 33.7 30.0 28.7 94.8 and services Imports of goods 18.8 83.0 33.3 32.2 27.2 80.7 and services

I 57.8 3.1 20.2

2.8

L

NL

0.4 15.9 – 0.9

A

P

8.1 10.0 0.5 0.4

FI

GR

5.2 10.6 0.3 0.4

47.6 25.2 25.3 11.5 25.4 11.6

0.7

2.6

2.1

3.6

3.5

7.3

28.3 19.4 26.2 31.6 29.0 33.3 20.4 68.9 79.9 71.1 66.3 67.4 63.1 72.3 28.4 151.5 67.2 50.1 31.7 42.7 25.1 27.2 129.1 62.4 51.1 43.1 33.2 33.1

Sources: ECB, BIS, OECD, IMF, Eurostat. a For Ireland: 1999.

ECB regularly publishes Eurosystem’s staff economic projections, which constitute a partial summary of the relevant information under the second pillar.3 When the European Monetary Institute was conducting its preparatory work on the ECB’s monetary policy strategy a number of alternative strategies, used by central banks were examined. The alternatives included monetary targeting, (direct) inflation targeting and exchange rate targeting.4 In this context an exchange rate targeting strategy was discarded. Quoting from EMI (1997): ‘ð. . .Þ an exchange rate objective is not considered appropriate since, for an area potentially as large as the euro area, such an approach might be inconsistent with the internal goal of price stability.’ In fact, exchange rate targeting strategies are normally followed by small open economies where economic developments are dominated by trade and financial linkages with the rest of the world. The euro area has to be regarded as a large and relatively closed economy (see Table I – key features of the euro area and euro area member countries – and Table II – key features of the euro area, the United States and Japan). Table I illustrates a similar pattern of sectoral composition of GDP for the countries participating in the euro area. The euro area comprises a population of more than 300 million people and accounts for about 16 per cent of the world’s GDP. The euro area is also relatively closed to international trade. Comparing the euro area with, for example, Germany, the largest national economy of the participating countries, the share of exports of goods and services over GDP is 19.7 per cent against 33.7 per cent. The share of exports of goods and services in the euro area ranges from 25.1 per cent in Greece to 151.5 per cent in Luxembourg.5 Table II shows that in terms of dimension the euro area ranks between the US and Japan. Nevertheless, the euro area is more open to trade in goods and services than either the US or Japan. Focusing on the US, Friedman (1968) dismissed the exchange rate as a suitable target for monetary policy using similar arguments: 3 See ECB (1999, 2000, 2001), Gaspar, Masuch and Pill (2001) and Issing, Gaspar, Angeloni and Tristani (2001) for a detailed account of the ECB’s monetary policy strategy. 4 See EMI (1997). Nominal GDP as an intermediate target and interest rate pegging were also examined. They were dismissed albeit for different reasons. 5 National trade measures include intra euro area trade while the euro area measure does not.


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Table II Key features of the euro area vis-a`-vis the United States and Japan (2000, in % of GDP, unless otherwise stated) Euro area

United States

Japan

304.3 16.0 21.5

275.4 22.0 38.6

126.8 7.3 40.6

2.4 28.5 69.1 19.7 18.8

1.4 24.7 73.9 11.2 14.9

1.4 30.8 67.7 10.8 9.4

Population (mn) GDP (share of world GDP,%) GDP per capita (EUR thousand) Sectors of productiona Agriculture, fishing, forestry Industry (including constr.) Services Exports of goods and services Imports of goods and services Sources: ECB, OECD, IMF, Eurostat. For Japan and United States: 1999.

a

‘ð. . .Þ the monetary authority should guide itself by the magnitudes that it can control, not by the ones that it cannot control ð. . .Þ. Of the various alternative magnitudes that it can control, the most appealing guides to policy are exchange rates, the price level as defined by some index, and the quantity of a monetary total ð. . .Þ For the United States in particular, exchange rates are an undesirable guide. It might be worth requiring the bulk of the economy to adjust to the tiny percentage consisting of foreign trade if that would guarantee freedom from monetary irresponsibility – as it might under a real gold standard. But it is not worth doing so simply to adapt to the average of whatever policies monetary authorities in the rest of the world adopt.’6

The world has, of course, changed substantially in the last thirty years. The importance of trade and financial linkages has increased. Nevertheless, this paper will argue that the thrust of the argument remains fundamentally unchanged. The paper is organised as follows. Section II will present a short account of relations between exchange rates and monetary policy in the short and the long run. The approach followed is conceptual. The emphasis is on the neutrality of monetary policy.7 Some illustrative empirical evidence will be presented. It will be argued that monetary policy cannot be used to control the real exchange rate in a lasting way. Under fixed exchange rate regimes monetary policy is determined by the constraints derived from nominal exchange rate stability. The rest of the paper will go on arguing that, for a large economy like the euro area, taking the nominal exchange rate as a target or a goal would be inappropriate. It could conflict with the primacy of internal price stability. Section III provides a short account of the literature on estimation and forecasting of exchange rates. A panel of estimates of equilibrium exchange rates for the euro will be presented.8 Section IV will describe the role of exchange rates in the ECB’s monetary policy strategy. Section V will conclude.

II.

Monetary Neutrality and Exchange Rate Determination

In this section a short primer on ‘what monetary policy can and cannot do’, focusing on exchange rates will be presented. In order to be effective in designing a monetary policy 6

See also Friedman (1953) especially pp. 198–200. Based on a very simple analytical framework taken from McCallum (1989), chapter 14. 8 From ECB (2002). 7


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regime and understanding its working it is essential to understand the limits of monetary policy. Addressing the fundamental question of ‘what monetary policy can and cannot do’ has motivated a lot of research especially after Friedman’s seminal Presidential Address, to the American Economic Association, in December 1967. Friedman (1968) does not address questions about exchange rate determination explicitly in his address. He refers however, in passing, to the exchange rate when he writes: ‘To state the general conclusion still differently, the monetary authority controls nominal quantities – directly, the quantity of its own liabilities. In principle, it can use this control to peg a nominal quantity – an exchange rate, the price level, the nominal level of national income, the quantity of money by one or another definition ð. . .Þ. It cannot use its control over nominal quantities to peg a real quantity ð. . .Þ.’ In Issing et al. (2001), when discussing the scope of monetary policy, focusing on the effects of monetary policy on prices and output, in the long run and in the short run, again no reference is made to exchange rates. This is the purpose of this section. It provides a selective review of the literature. Consider a simple (standard) stochastic model, in discrete time, of an open economy,9 under floating exchange rates described by equations (1) to (7) mt  pt ¼ ay yt  ai it þ mt

ð1Þ

ytd ¼ br rt þ bq qt þ by yt þ zt

ð2Þ

e  pt Þ rt ¼ it  ðptþ1

ð3Þ

qt ¼ et þ pt  pt

ð4Þ

it ¼ it þ ðeetþ1  et Þ

ð5Þ

ytd ¼ yts ¼ yt

ð6Þ

yts ¼ ~y

ð7Þ

The variables m; p; y; i; q; e; r, denote respectively the money stock, the price level, output, the nominal interest rate, the real exchange rate, the nominal exchange rate and the real interest rate. The subscript t denotes time. The superscript * denotes variables corresponding to the rest of the world. The superscripts s and d denote respectively supply and demand. The superscript e denotes an expected value. All variables are expressed in logs except for interest rates. Finally mt and zt denote stochastic shocks according to processes to be specified later on. All parameters aj and bj are defined to be positive. Equation (1) is a standard money demand equation. Demand for money is increasing in domestic output. Output is here used as a proxy for the volume of transactions which affect money demand. Demand for money is decreasing in the nominal interest rate. Once money supply has been defined, and marketclearing has been imposed, equation (1) can be used to derive a LM relation. As in McCallum 9 This model is standard in the literature. See, for example, Flood (1981), Mussa (1982,1984), Obstfeld (1985) and Krugman (1991). The presentation here follows closely McCallum (1991) and Gaspar and Abreu (1999).


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(1989) the formulation (1) above rests, in the context of an open economy, on at least two simplifying assumptions: First, the scale variable is domestic output while, arguably, a better measure would be provided by domestic expenditure. Secondly, money supply is deflated by the price of domestic goods while a more correct measure would also take into account imported goods prices. However, these simplifying assumptions do not change significantly the properties of the model and they can be justified as ‘approximations’ if the degree of openness of the economy is not ‘too large’. Equation (2) defines the expenditure function for domestic output. The real interest rate has a negative impact on expenditure. In contrast, foreign output and the real exchange rate increase demand for domestic output. The real interest rate is defined as the nominal interest rate minus expected domestic inflation (equation (3)). Equation (4) defines the real exchange rate, q. The real exchange rate is defined as the relative price of the foreign output. In the expression the nominal exchange rate, e, is defined as the number of units of domestic currency per unit of foreign currency.10 Therefore an increase in e (or q) is to be interpreted as a depreciation of the domestic currency (an appreciation of the currency of the rest of the world).11 Equation (5) represents the uncovered interest rate parity equation. The domestic nominal interest rate is assumed to be equal to the foreign nominal interest rate plus the expected depreciation of the domestic currency. Equation (5) could be extended to incorporate a (timevarying risk) premium. For analytical simplicity this risk premium is assumed to be constant and neglected in the subsequent analysis.12 Equation (6) simply states the equilibrium condition in the market for domestic output. Finally equation (7) postulates an exogenous level for domestic output at ~y . ~y will be referred to below as potential output. The assumption of exogeneity of the domestic output corresponds to a classical assumption of full flexibility of prices and wages making the level of (real) domestic output independent from aggregate expenditure. It implies monetary neutrality. It is an important assumption that deserves further comment. For the moment it suffices to say that it may be shown that the solution of the model above corresponds to the steady-state solution of models incorporating price stickiness. From an analytical viewpoint, the monetary neutrality result allows for the direct derivation of an expression for the equilibrium real exchange rate.13 The expression will be independent from the monetary side of the model. Consider first the deterministic case (mt and zt are assumed to be identically zero). Under full flexibility of prices (and wages) it is easy to solve for the equilibrium real exchange rate 10 The convention for the euro is the opposite. The exchange rate of the euro is defined as the number of units of foreign currency per euro. According to this convention an increase in the exchange rate corresponds to an appreciation of the domestic currency. According to the convention used in the model the opposite is true. An increase in the exchange rate corresponds to a depreciation of the domestic currency. 11 An implicit assumption made is the so-called ‘producer currency pricing’ which has dominated most of the international macroeconomics literature. Producer currency pricing is key in delivering an immediate effect of exchange rate changes on the relative price of domestic and foreign goods. This view has been challenged as incompatible with empirical evidence. An alternative paradigm is provided by the ‘local currency pricing model’ (see, for example, Devereux and Engel (2001)). The proponents of this approach claim that local currency pricing eliminates the pass-through from exchange rate changes to consumer prices thereby helping to explain high nominal and real exchange rate volatility. The assumption of ‘producer currency pricing’ matters only when departing a flexible price formulation. 12 In the early 1980s it has been found that the forward rate is not an optimal predictor for the future spot exchange rate. Since the forward rate is a function of the interest rate differential according to the covered interest rate parity condition this is evidence against the empirical relevance of the uncovered interest rate parity condition (see, for example, Frankel (1980), and Frankel and Rose (1995)). 13 Focusing directly on the derivation of the expression for the real exchange rate allows a simpler derivation than the one presented in McCallum (1989).


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qt ¼ ð~y þ br rt  by y  Þ=bq

ð8Þ

The expression for the equilibrium real exchange rate in equation (8) is interesting. In fact, as indicated above, the equilibrium real exchange rate is determined as totally independent from the monetary side of the model. This does not, of course mean, that the real exchange rate should be regarded as constant or immutable. On the contrary, equation (8) shows that – in the context of this model – an increase in the supply of domestic output leads to an increase in the real exchange rate, that is to a decline in the relative price of domestic output. The reason being that depreciation is needed to bring up demand for domestic output so as to match the increased supply.14 An increase in the real interest rate in the rest of the world leads ceteris paribus also to a real depreciation of the domestic currency. It is so because an increase in the world interest rate – through its influence on domestic interest rates – leads to a decline in the demand for domestic output.15 Finally, an increase in income in the rest of the world leads to an increase in demand for domestic output and, therefore, to an increase in its relative price. The results are very intuitive: increases in supply (demand) of domestic output lead to decreases (increases) in its relative price. It is clear that a more complete version of the model above would lead to a much longer list of determinants for the equilibrium real exchange rate. The list would include at least: the level and composition (between domestic and foreign goods) of government’s expenditures; taxes and trade policy at home and abroad; risk premia in financial markets; and so on (see, for example, Edwards (1989)). It would also include all factors affecting the growth of potential output or technological progress. To repeat, it should be clear that there is no reason to believe that the equilibrium real exchange rate should be constant over time. On the contrary, the real exchange rate may be interpreted as a relative price and is therefore a highly endogenous variable. It is not, however, a variable that, in long run equilibrium, can be influenced by monetary forces.16 This is clear from equation (8) and the extensions which have been outlined. More on this is to follow. Empirical evidence shows prolonged swings in real exchange rates. In some cases there is even an apparent trend in real exchange rates. The most relevant observations come from countries undergoing fast growth in the context of a successful catching-up process to higher levels of GDP. These countries typically experience real appreciation of their currencies. This fundamentally departs from the result suggested by the model above. Indeed the most relevant factors to explain this phenomenon operate on the supply side of the economy.17,18 In any 14

Another possible channel of adjustment would be provided by changes in the real interest rate. Such channel cannot operate here as the domestic interest rate is determined in equilibrium by the world interest rate through the uncovered interest parity relation. 15 Here the level output in the rest of the world is taken as given. 16 Friedman (Friedman (1968)) makes an analogous point concerning the ‘natural’ rate of unemployment. Recall that Friedman’s definition of the natural rate is ‘the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of labour and commodity markets, including market imperfections, stochastic variability in demand and supplies, the cost of gathering information about job vacancies and labour availabilities, the cost of mobility and so on’. Friedman goes on to emphasise that many of the relevant characteristics of the labour market are indeed ‘policy made’. He mentions explicitly among other factors minimum wages and the strength of labour unions. 17 The structure of the supply side of the economy was disregarded in the formulation adopted. 18 Summers and Heston (1991) document widely different price levels, for identical quality-adjusted baskets of goods, across a large sample of countries. In the data the price level is strongly correlated with per capital real income. Balassa (1964) and Samuelson (1964) relate differences in international price levels to differences in relative productivity in the tradables and non-tradables sectors (see Obstfeld and Rogoff (1996).
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case it is important to carefully distinguish between being able to identify a set of factors determining the equilibrium real exchange rate, in ‘steady state’ equilibrium, and being able to estimate it accurately (see Section III below). Consider now the monetary side of the deterministic case (mt and zt are still assumed to be identically zero) and solve for the steady state. Consider further that the level of potential output is unchanging over time D~y ¼ 0, the level of foreign output is constant Dyt ¼ 0 and that money grows at a steady rate at home and abroad. Specifically Dm ¼ l. In the rest of the world money also grows at a steady rate l . It makes therefore sense to assume that the following conditions hold in the rest of the world:19 Dm ¼ Dp ¼ l and i ¼ r þ Dp . Deriving the path for domestic prices, pt , is easy by differencing equation (1) to obtain l  Dp ¼ ay Dyt  ai Dit : Now both terms on the right hand side are null. The first by assumption and the second as a result of the steady state conditions. But then Dp ¼ l immediately follows. Moreover under the conditions assumed the real exchange rate is unchanging as well ðDq ¼ 0Þ. From this it follows that De ¼ l  l ¼ Dp  Dp :

ð9Þ

That is, under the conditions described, the nominal exchange rate depreciates fully in line with the inflation rate differential. The model therefore implies a version of the so-called relative purchasing power parity (PPP) doctrine. The doctrine seems to have originated from Cassel (1922) who believed that exchange rates would tend to adjust in order to equalise prices across countries. Normally the starting point for the derivation of the PPP is the law of one price. It states that for each good i pti ¼ et  pti



where pi denotes the price of the good i. The premise leading to the law of one price is goods markets arbitrage. That is assuming away imperfect competition, barriers to trade and transport costs trade should ensure price equalisation. If the law of one price applies to each individual product it also applies to any identical aggregate of goods. If PPP applies in levels it also applies in first differences. In any event, the argument relevant for the derivation and interpretation of the results above does not rely on goods markets arbitrage and the law of one price. To understand this it is enough to notice that the two price indexes compared in (9) are different. p corresponds to domestic output while p is the price of foreign output. The empirical verification of (9) relies on two premises. First, movements in prices, over the last hundred years or so, have been dominated by monetary factors. In other words, price developments over the long run are associated with commensurate changes in the money supply. Second, long run monetary neutrality. Monetary neutrality implies that a permanent increase in the quantity of money will be eventually reflected in a proportional change in the price level and the nominal exchange rate without any permanent impact on real magnitudes. In the model a proportional change in the money stock leaves economic activity (by assumption) and the real exchange rate unchanged.20 Under these two conditions relative PPP will provide a good approximation quite independently from the verification of the law of one price. 19

This conjecture corresponds to the results that are about to be derived for the domestic economy. An increase in the growth rate of money supply would lead to an increase in the rate of nominal depreciation of the currency, an increase in the nominal interest rate and a decline in real money demand. 20


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Figure 1a.

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Cross-country exchange rate changes and inflation (1960–1998; yearly averages)

Figure 1b. Cross-country exchange rate changes and inflation (1970–1998; yearly averages; countries with inflation