Asymmetry in The EMS

Various international monetary regimes organizing international currency transactions have emerged since the breakdown of the Bretton Woods System in the early 1970s. In addition to the standard exchange rate regimes, fixed and flexible, other intermediate forms of exchange rate management have been adopted by many countries at different periods of time. The question that naturally arises is, among these alternatives, what is the best exchange rate system? Obviously, if there were an exact answer to this question, all nations would adopt the same exchange rate regime. Unfortunately, there is no simple answer. specific The central purpose of this paper is to consider theoretically and empirically one exchange rate system which has been used by many European countries in the last three decades. This is the target zone arrangement, which can be represented by the European Monetary System (the EMS). Generally, it belongs to fixed exchange rate system. However, it pegs the exchange rate inside a band rather than on a fixed value by setting the central parities for each currency with some flexibility around these parities within a band. It is expected to combine elements of both fixed and flexible exchange rates. Under fixed exchange rates, it is difficult to peg the exchange rate at one fixed value and domestic (monetary) policy is subservient to international conditions and shocks. On the other hand, a freely floating exchange rate is subject to volatility and uncertainty. International capital mobility makes it difficult to insulate the national economy from uncertainly emanating financial shocks. The target zone system that we investigate in this paper is a mechanism by which some of the costs of fixed and flexible exchange rate systems are sought to be minimized. Alternatively, the gains from having one or other of the two polar alternatives can be increased. By fixing the exchange rate within a band, the impact of volatility and uncertainty for the domestic real economy and the trade balance is sought to be reduced. With flexibility in a band, some independence of monetary policy can be preserved with the domestic interest rate (and the inflation rate) having the ability to diverge form world rates. Hence, the monetary authorities can pursue a ‘relatively’ independent monetary policy in response to shocks and attempt to stabilize the economy when there are business cycles. However, the efficiency of adopting such a regime depends on the maintenance of bilateral fluctuation bands involving the EMS currencies being, for all currencies except the lira, 2.25 percent on each side of bilateral central rates. The lira can fluctuate up to 6 percent on each side of bilateral central rates. When the asymmetries of economic targets exist among member countries, realignments or misalignments might occur. Miller and Weller (1989) indicated that monetary independence and exchange management policies might be incompatible within a fixed exchange rate system. Giovannin (1989) also pointed out that asymmetries are the difficulties faced by the countries adopting the fixed exchange rate system. However, they did not concern the effects of exchange rate stability requirement on domestic macroeconomic goals. Following EMS rules, member countries should neither depreciate their currencies to improve trade balance nor lower domestic interest rate to stimulate domestic demand. Salvatore (1997) thus indicated that the EMS countries could not simultaneously have exchange rate stability, free capital mobility, and monetary