This paper investigates the volatility of exchange rates and interest rates of member countries of the exchange rate mechanism (ERM) of the European Monetary System (EMS) by comparing it with that of a control group of non-ERM currencies before and after the inception of the ERM. Because there are doubts about the true distribution of exchange rate and interest rate changes, a nonparametric method is used. It also examines how volatility changes over time.
The essential findings are very clear. During the operation of the EMS, the volatility of intra-ERM (specifically bilateral-deutsche mark) exchange rates fell, whereas the volatility of non-ERM currencies has remained the same or increased. This effect was big enough to also replicate itself for the ERM countries’ overall effective exchange rates. Similar conclusions, albeit not quite so striking, were obtained for real bilateral and real effective exchange rates. The general impression that the ERM had evolved over time in the direction of greater stability is also confirmed on this data set.
The same technique is applied to study the evolution of volatility in “offshore” or “Eurocurrency” interest rates. Again, volatility appears to be somewhat reduced for the ERM countries compared with the control group. This result is inconsistent with the “volatility transfer” hypothesis according to which reduced stability in exchange rates would imply added volatility in interest rates. Moreover, the high-frequency volatility of ERM interest rates did not shift significantly during the time the United Kingdom was participating in the ERM.
Drawing on earlier work by the present authors on the long-run credibility of the ERM and taking into account the distinction between short-run volatility and long-term misalignment, the paper argues that the very recent turbulence in the EMS is not inconsistent with the short-run, stabilizing influence of the ERM that is documented here.