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This paper was originally prepared for a Fund-sponsored conference on exchange rate policies of industrial countries held in Brussels on October 12-14, 1989. It will be published by the Fund in a volume of conference proceedings. The authors wish to thank the participants in that conference, their colleagues in the European Department, and Charles Adams and Paul Masson for many helpful comments.
This is described as the “hard currency option.”
If the demand for high-powered money depends on the expected inflation rate, rather than income alone, then even temporary control of the monetary base becomes impossible without subordinate fiscal policy.
Optimal inflation rates may depend in part on the structure of the tax system; see Guidotti and Végh (1989).
Another is to look directly at the extent to which potential members currently rely on revenue from seigniorage, and compare this with what would accrue in a fixed exchange rate regime. An example is Gros (1989), who looks at the effects of EMS and financial market integration together, and concludes that only for Portugal and Greece might the losses be substantial. Cohen and Wyplosz (1989) make the point that, in principle, the members of a hard currency area could earn joint seigniorage by inflating relative to the rest of the world, and share the proceeds in such a way that no country would need to lose revenue.
On the basis of net general government debt outstanding.
In fact, the Belgian Government’s strategy does involve a reduction in the deficit as a proportion of GDP over the medium term, so that the debt ratio could be expected to fall (see OECD (1989) for a description of the strategy).
And no government, of course, can ignore the effects of its fiscal policy on longer-term economic performance.
Provided the anchor country has such a framework, as Germany does.
Unfortunately, it is not possible to argue that this pseudo-competitive behavior would be assured simply by financial markets’ attaching realistic risk premia to government debt. Markets are concerned only with the expected return on their assets, and for governments, unlike private corporations, this return is a function not only of the viability of the project being financed but also of the government’s ability to raise taxes. The existence of efficient financial markets is not, therefore, sufficient to eliminate the spillovers described above.
See Roubini (1989) for some model simulations demonstrating this phenomenon in the United States-European context.
In most models the gains from this strategy would only be temporary. Nevertheless, as Sachs (1983) argues, it would still be worthwhile for a government interested in smoothing the adverse effects of an inflationary shock.
See Amalric and Sterdyniak (1989) for a demonstration of the different effects of symmetric and asymmetric shocks.
The simulations reported in Roubini (1989) imply that this problem would also exist in a hegemonic, deutsche mark-led hard currency regime. However, in this case, the externalities from German fiscal expansion would be greater than from a similar policy shift in France. Assuming that Germany follows a fixed money supply rule and that France adjusts its monetary policy in order to maintain the franc-deutsche mark parity, a German fiscal expansion forces a monetary tightening in France. A French fiscal expansion, on the other hand, must be accommodated by faster monetary growth in France. Hence, the European currency appreciates more vis-à-vis the U.S. dollar in the former case than in the latter, and the resulting externalities are correspondingly affected.
Cohen and Wyplosz point out that it is primarily temporary rather than permanent shocks which cause these problems, since the motivation for “smoothing” is stronger when shocks are temporary.