Abstract

By drawing on an analysis of the role of monetary policy in balance of payments adjustment under different monetary systems and exchange rate arrangements, this paper focuses on the crucial issues involved when an attempt is made to set rules for monetary policy coordination in a system of fixed but adjustable exchange rates such as the European Monetary System (EMS). A proper functioning of the balance of payments adjustment mechanism is crucial for the stability of an exchange rate system. In turn, the proper working of the adjustment mechanism can be sought either through “rules,” which make the adjustment automatic, or through prompt “discretionary” changes in monetary policy, which require a close degree of cooperation among the central banks of the member currencies (and the political willingness to subordinate, when necessary, internal objectives to the external constraint).

By drawing on an analysis of the role of monetary policy in balance of payments adjustment under different monetary systems and exchange rate arrangements, this paper focuses on the crucial issues involved when an attempt is made to set rules for monetary policy coordination in a system of fixed but adjustable exchange rates such as the European Monetary System (EMS). A proper functioning of the balance of payments adjustment mechanism is crucial for the stability of an exchange rate system. In turn, the proper working of the adjustment mechanism can be sought either through “rules,” which make the adjustment automatic, or through prompt “discretionary” changes in monetary policy, which require a close degree of cooperation among the central banks of the member currencies (and the political willingness to subordinate, when necessary, internal objectives to the external constraint).

After recalling the main lessons from the gold standard and the Bretton Woods system, the analysis will focus on the EMS as it works at present. All three are systems of fixed but, in different degrees, adjustable exchange rates.1 In Section II the two main lessons from the earlier international monetary regimes are summarized: first, that in a system of fixed exchange rates the money supply of at least n–1 participants must remain endogenous if the adjustment mechanism is to work smoothly. To put it differently, a fixed monetary rule for the total stock of money (but not for the domestic component of the monetary base) is incompatible with a system of fixed exchange rates, unless such a rule is reserved implicitly or explicitly for a recognized leader of the system. Second, a stable system needs a rule governing “world” inflation, however measured, or the inflation target of the group of countries participating in it, as well as a rule governing the reaction of countries’ economic policies to deviation of actual inflation from the desired path. This section also examines briefly the special role played by the United States in the Bretton Woods system.

Section III is devoted to an analysis of the degree of monetary policy coordination and convergence of inflation and interest rates reached by EMS countries. In particular, we investigate the role of the Federal Republic of Germany in the fight against inflation and the balance of payments adjustment mechanism within the EMS. No explicit rule concerning inflation exists at present in the EMS, but there has been an accepted unwritten rule since 1982–83: Germany decides its domestic inflation rate and all other members adopt policies to adjust their own gradually to it; i.e., the German inflation rate has become the target inflation rate of the system.

Section IV deals with the question of how balance of payments adjustment and attainment of the inflation objective could be facilitated through the adoption of rules for coordination of monetary policy that would make the adjustment mechanism more symmetrical. Four possible rules are examined: first, the adoption, ex ante, of an aggregate money supply rule for EMS member countries—an application of the proposal McKinnon (1984) made for Japan, the United States, and Germany in the context of the reform of the international monetary system; second, a rule derived from the first involving the expansion of the domestic component of the monetary base (i.e., money of domestic origin) in each member country coupled with the nonsterilization of international reserve flows; third, a nominal income rule adopted by each member country that should, however, be consistent with both the (independently determined) growth and inflation objectives of each and the aim of convergence within the system; and fourth, a rule consisting of the adoption of a common inflation target individually pursued by each country with a suitable monetary policy designed to achieve it.