Characteristics of the Euro, the Demand for Reserves, and Policy Coordination Under EMU

Abstract

The success of European Economic and Monetary Union (EMU) will depend on the stability of the euro. The monetary policy framework is yet to be decided, but is likely to involve either money or inflation targeting. Stochastic simulations compare the outcomes for major macroeconomic and financial variables pre-and post-EMU under both policy rules, as well as under an inflation targeting rule that includes output. Implications for the euro as a reserve currency are examined in the light of the expected returns and covariances among reserve currencies. The role of the exchange rate as an indicator and incentives for policy coordination with other major countries are also discussed.

The Euro and Developing Country Finance

“…In addition, when compared to the weights embodied in the SDR (using September 2005 exchange rates), the euro's optimal portfolio weight is 5 percentage points lower, sterling's 2 percent higher, and the yen's about equal, while the dollar's optimal share (43 percent) is 3 percent above its SDR weight (40 percent). The proportion for the euro is significantly below that calculated for the deutsche mark in Masson and Turtelboom (1997), despite a similar methodology. The reason is that in that study, the mean returns (calculated over 1981-95) on both deutsche mark and yen were considerably higher than dollar returns, and they were less variable as well.…”

“…This was the interpretation given in Masson and Turtelboom (1997), where a mean-variance model with historical returns were used to calculate optimal reserve holdings, in dollars, yen, and euros. In order to consider global reserve demand, returns were expressed in terms of the SDR, chosen as the numeraire.…”

“…Since both Masson and Turtelboom (1997) and Kool (2000) relied on data for the deutsche mark (and other European currencies replaced by the euro), rather than for the market intervention. See below.…”

One World Money, Then and Now

“…A number of economists (e.g. Bergsten(1997Bergsten( , 1999, Masson and Turtelboom(1997), Portes and Rey(1998)) have suggested that exchange rate volatility between the dollar and the euro may well be higher than it was between the dollar and the German mark before 1999. The reasons are partly structural --euroland is much more self-contained than the individual countries were, so exchange rate variation will cause fewer internal disturbances, hence fewer calls for action to stabilize exchange rates; This greater volatility could be greatly aggravated if during the next decade foreign exchange holders around the world decide to switch their claims substantially from US dollar-denominated ones to euro-denominated ones, as some have suggested will occur (e.g.…”

EMU: Why and How It Might Happen

“…This prediction derives from the constitution of the European Central Bank, which makes it more independent and more focused on price stability than the U.S. Federal Reserve. If anything, the constitution is even stricter than that of the Bundesbank, so that Europe's economy will be more stable than Germany's (Masson and Turtelboom, 1997). A counterargument is based on politico-economic considerations.…”