Monetary Policy in a Converging Europe

With the date of the start of Stage Three of Economic and Monetary Union (EMU) rapidly approaching, the interest of central bankers and academics in various topics related to monetary policy in a converging Europe is increasing strongly. This book contains contributions from experts on subjects such as experiences of countries which have recently adopted a monetary policy strategy of direct-inflation-targeting, increasing monetary interdependencies in ERM countries, money demand (in)stability and the possible consequences for monetary policy co-ordination in Europe, credit characteristics and the monetary policy transmission mechanism in various industrialised countries, and finally the issue of which exchange rate policy to pursue in the run-up to the start of Stage Three.

This paper examines whether inflation targets have been instrumental in reducing the policy-implied, short-term trend rate of inflation, which is defined as the baseline inflation rate. To investigate whether announced targets have generated distinct benefits in terms of reductions in the baseline inflation rate to date, the authors compare the baseline inflation rates in three inflation-targeting countries with those in neighboring non-inflation-targeting countries. The study matches New Zealand with Australia; Canada with the United States; and the United Kingdom with Germany.

The comparative analysis stemming from an indicator model using a Markov-switching process suggests that inflation targets have brought about a change in inflation preferences in the 1990s. This statement needs to be qualified however, because the inflation-targeting countries generally followed a non-inflation-targeting neighbor in reducing their baseline inflation rates. The United States and Germany shifted to a low baseline path prior to similar shifts by their inflation-targeting neighbors. Given that the neighboring countries moved first and appear to have settled on a lower baseline inflation rate, it is difficult to determine how instrumental the targets were in bringing about the shift in preferences.

Two versions of the P-star model (P*) of inflation are tested for Belgium, France, Germany and the Netherlands for the period 1973.I–1992.IV. In the first, conventional version the statistical links between national monetary aggregates and domestic inflation are examined. Conversely, the chosen set up in the second version allows for symmetric monetary spill-over effects between these countries. The estimates suggest that inflation in Belgium and the Netherlands is nowadays fully determined by the European price gap and not by domestic monetary conditions, while the relative importance of the European price gap is increasing in the case of France and Germany. All in all the European price gap provides an accurate indicator for future inflationary tendencies in all four countries. Moreover, we find that the European inflation equation is stable over the sample period. Taken together these results suggest that (implicit) targeting of a European monetary aggregate in addition to explicitly targeting the German money supply may become necessary to achieve and maintain price stability in Europe in the near future.

This paper examines in detail the characteristics of credit to the non-government sector, including both interest and non-interest terms, in fourteen industrial countries and considers its potential implications for the transmission mechanism of monetary policy. Three findings merit particular attention. First, the share of securities in total credit is comparatively high in Anglo-Saxon countries. Second, most Anglo-Saxon countries are characterised by a relatively high share of adjustable rate credit. This is due primarily to the widespread use of adjustable rate mortgages by households. Outside the Anglo-Saxon group, the main exception is Italy; inside it, the United States. Third, the share of loans backed by real estate collateral appears to be comparatively high in most Anglo-Saxon countries. Elsewhere, it is very high in Sweden and Switzerland. There are also indications that the share is relatively high in Japan. To varying degrees, the above characteristics should be expected to amplify the impact of monetary policy on economic activity. Their relevance is broadly consistent with the cross-country pattern of results of simulations of national central bank models.

Two issues are discussed. The first is which countries might benefit from entry into EMU before the millennium. Germany and her immediate neighbors appear the most likely to benefit; however, our knowledge is too uncertain to say whether all, some, or no countries would reap economic benefits. The second issue is how to avoid exchange rate instability in the transition to EMU. Experience from earlier exchange rate regimes suggests that an early announcement the parities at which different currencies would enter EMU could reduce such instability if governments were willing to accept the required limitations on domestic policies.

The workshop was concluded by a panel discussion with the title “The Best Way to EMU”. The objective was to place the issues that had come up in the presented papers in a broader policy perspective. The panel consisted of professor Thygesen from the University of Copenhagen, professor De Grauwe from the Catholic University of Leuven, professor Bakker from the Dutch central bank (DNB), and Mr. Hogeweg from the European Monetary Institute (EMI).