Jens Thomsen: Monetary policy in the shadow of a monetary union1
Speech by Mr Jens Thomsen, Governor of the National Bank of Denmark, at the inauguration of the
monetary policy committee at the Bank of Ghana, Accra, 9 September 2002.
The references for the speech can be found on the National Bank of Denmark's website.
* * *
1. Introduction
There is presently little disagreement among economists that the ultimate goal of monetary policy
should be price stability. Indeed, in the statute of the recently established European Central Bank price
stability is clearly stated as the primary objective of the bank, and it is made clear that support of the
general economic policies in the Community is only a secondary objective.
In pursuing the final target of price stability, different countries have chosen different intermediate
targets to guide their monetary policy. During the last decade several countries have switched to a
monetary regime based on inflation targeting.2,3 Since monetary policy is only effective with some lag,
and since excessive output losses are to be avoided, inflation-targeting central banks seek to control
inflation over the medium term. Expected future inflation at a given horizon thus serves as the
intermediate target for an inflation-targeting central bank.
This article will, however, focus on another intermediate target: the exchange rate.4 Before the
creation of the European Monetary Union, most of the EU member states participated in the European
Monetary System - a fixed-exchange-rate system based on a grid of bilateral central parities and
intervention bands. Currently, three EU member states have not adopted the euro: while the UK and
Sweden have inflation-targeting regimes and a floating exchange rate vis-à-vis the euro, Denmark
follows a fixed-exchange-rate policy vis-à-vis the euro. The intermediate target for Danish monetary
policy is thus the krone/euro exchange rate.
The new European fixed-exchange-rate system, ERM II, came into operation on 1 January 1999 and
Denmark became a member immediately, with a narrow fluctuation band of +/- 2.25 per cent around a
central parity of 746.038 kroner per 100 euro. The favourable convergence position of the Danish
economy made it possible to conclude an agreement on a narrow band. The standard fluctuation band
in ERM II is +/- 15 per cent.
Membership of ERM II was not a major change of the Danish monetary regime. As a matter of fact,
Denmark has a very long tradition for a fixed-exchange-rate policy. The central parity vis-à-vis the euro
corresponds exactly to the former central rate vis-à-vis the D-mark, which was unchanged from early
1987, cf. Chart 1. Furthermore, by 1982, exchange-rate realignments had ceased to be a self-initiated
Danish policy instrument.
The firm commitment to a fixed-exchange-rate policy originates from very poor performance of
macroeconomic policy and, consequently, poor performance of the Danish economy in the 1970s.
Against the background of high inflation, excessive budget deficits, permanent deficits on the current
account of the balance of payments, frequent devaluations of the krone and high nominal interest
rates, the Danish authorities in the early 1980s made a successful U-turn to a stability-oriented
macroeconomic regime. The fixed-exchange-rate policy was, and still is, an important element in the
macroeconomic framework in Denmark. See Christensen and Topp (1997) for a more detailed review
of the change in Danish economic policy in the aforementioned period.
While participation in ERM I and ERM II have been beneficial to the Danish economy in its own right,
these exchange-rate systems and the successful introduction of the euro should be viewed in a much
broader context than from a purely monetary policy perspective. EU member states co-operate on a
large range of political and economic issues and have set up a common legal and institutional
framework, of which the ECB is only one example. This probably contributed to a smooth transition to
a common monetary policy.
The krone vis-à-vis the German mark and the euro Chart 1
DKK / DEM
3,0
3,2
3,4
3,6
3,8
4,0
4,2
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
DKK/DEM Central parity, DKK/DEM
Note: From 1 January 1999 a conversion has been made to depict DEM instead of EUR.
The paper is organised as follows. The first part covers the structural macroeconomic facts of
importance for the fixed-exchange-rate policy. The second part deals with the technical and tactical
aspects of monetary-policy implementation in ERM II. The paper concludes that a fixed nominal
exchange rate vis-à-vis the euro is beneficial for a small open economy such as Denmark.
2. The Danish fixed-exchange-rate Policy
It is important to emphasise that the Danish exchange-rate policy is a fixed-exchange-rate policy, and
not a fixed, but adjustable, exchange rate. Taken literally, this can only be true with euro area
membership. However, in a Danish policy context it means that all macroeconomic policies are
conducted with a view to ensuring a fixed exchange rate. There is no contingency plan if things go
wrong.
The two key conditions for success are a strong commitment from the authorities to abstain from
creating "home made" shocks (which according to the Danish experience are far more important than
exogenous external shocks) and an unconditional willingness to subordinate monetary policy to the
exchange-rate strategy.
Price stability
A first test of the benefits of a monetary regime is to see if it delivers on the final goal. For a central
bank the key issue is price stability, and the Danish monetary regime passes the test. Inflation
measured as the percentage annual increase in the harmonised consumer price index (HICP) has
been stable at around 2 per cent in Denmark since the early 1990s, cf. Chart 2. The persistence of low
inflation has furthermore been conducive to low inflationary expectations. In the period since the
announcement of the fixed-exchange-rate policy low and stable inflation has been achieved without
loss of income relative to our major trading partners, Germany, Sweden and the UK, although it should
be recalled that the transition to a low-inflation economy is not an isolated Danish phenomenon. Most
OECD countries have achieved the same in the last decade, independently of their monetary-policy
regimes. Consequently, Danish inflation performance cannot be taken as a general proof of the
superiority of a fixed-exchange-rate regime.
Increase in harmonised index of consumer prices in Denmark,
Germany and the euro area Chart 2
Per cent, y-y
7
6
5
4
3
2
1
0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Denmark Euro Area Germany
Monetary policy and the business cycle
Output gap in Denmark, Germany and the euro area Chart 3
Per cent
5
4
3
2
1
0
-1
-2
-3
-4
-5
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
Denmark Germany Euro area
Note: 2002 and 2003 are projections.
Source: OECD Economic Outlook.
A fixed-exchange-rate policy implies that the stance of monetary policy is from time to time out of line
with domestic short-term cyclical needs, and is potentially a destabilising factor. When key
monetary-policy interest rates are closely linked to German interest rates, and since 1999 euro-area
interest rates, there is no room for independent domestic stabilisation by means of monetary policy.
This problem appears to be particularly severe in Denmark, where the business cycle - at least
according to visual inspection - seems to be negatively correlated with the cyclical conditions in
Germany and the euro area, cf. Chart 3. However, it is also possible to draw a completely opposite
conclusion from the deviation in the cyclical patterns: cyclical divergence is immaterial to the success
of a fixed-exchange-rate policy.
The monetary-policy transmission mechanism is of crucial importance in the choice between
business-cycle and exchange-rate stabilisation. The direct effect from changes in short-term interest
rates to domestic demand is comparatively small in Denmark. The terms for mortgage financing, which
is the most important transmission channel to the household sector, are predominantly based on fixed
20-year or 30-year mortgage bond yields. Variable mortgage lending at 1-5 year interest rates has,
however, gained in importance in recent years, but is still at a relatively low level.
The basic textbook model includes only one policy instrument for short-term stabilisation - monetary
policy. This is a standard formulation in the literature and also in line with practice in most
industrialised countries. Discretionary fiscal policy came into disrespect after the abuse of the
instrument in the 1960s and 1970s, which led to stagflation, large budget deficits and high public debt
in many countries. Denmark has also suffered from this experience, but discretionary fiscal policy is
still used to stabilise the economy. It is important to underline that the frequency of discretionary fiscal
measures is low and far below the frequency of monetary-policy changes in countries with other
monetary regimes. The government does not meet every two weeks to consider an adjustment to e.g.
the VAT rate following the latest business-cycle information. During the past decade discretionary
fiscal stabilisation measures outside the normal central-government budgetary calendar have been
introduced on three occasions: temporary expansive measures in 1993, and contractive measures in
1997 and 1998. Furthermore, the appropriate macroeconomic impulse from the government budget to
output is also taken into consideration in the annual budget negotiations. In years when fiscal policy
has not been used for stabilisation purposes the fiscal impulse, i.e. the contemporaneous contribution
to GDP-growth from fiscal policy in a given year, has been close to zero. As is the case in most
countries it is also politically easier to increase public expenditure and reduce taxes than the opposite
in Denmark. However, it is not our assessment that the reliance on a fixed exchange rate and
occasional discretionary fiscal policy measures in itself has exacerbated this inherent problem.
Quite the contrary, the fixed-exchange-rate policy has been instrumental in the significant
improvement in Danish economic policy that has taken place in the last 10-15 years. The Danish
government, supported by a large majority in the Danish parliament, is committed to use fiscal policy if
inflationary developments are out of line with the exchange-rate policy. It has been publicly announced
that fiscal policy will be adjusted if inflation deviates from the ECB's definition of price stability (0-2 pct.
increase in the harmonised index of consumer prices - HICP).
Fiscal measures are taken with due regard for developments in government debt as well as in the
current account. Indeed, except for 1998 Denmark has had a surplus on the current account of the
balance of payments since 1990, while there has been a surplus on the government budget since
1997. Furthermore and equally important, the fixed-exchange-rate policy has brought structural
reforms of the tax and benefit systems and the labour market to the policy forefront as the necessary
tools to ensure low unemployment and growth in real income.
Asymmetric shocks, home-made shocks and exchange-rate policy in Denmark
A floating exchange rate is often considered useful in order to insulate an economy from certain
shocks in a world with nominal wage rigidity and/or limited labour mobility. A fixed-exchange-rate
policy can lead to excessive and protracted unemployment in such a world, and adjustment to
asymmetric shocks is - at least in theory - an important argument against a fixed-exchange-rate
policy. However, the importance of this argument requires answers to the following two questions: 1)
What causes large positive and large negative output gaps? 2) Is a floating exchange rate an efficient
shock absorber?
The Danish economy was in severe slump in 1981, reached a peak in 1986, went back into a period of
slow growth, bottoming out in 1993, and has grown strongly since and exhausted the negative output
gap, cf. Chart 3. The business cycle was also out of line with Germany as well as the entire euro area.
The business cycle in itself and the deviation to the German business cycle cannot be explained by
exogenous external factors. Firstly, the demand for Danish exports did not deviate from the trend to an
extent that can explain the cyclical swings in the period under observation. Secondly, the terms of
trade moved more or less in line with the terms of trade for other EU member states, ruling out
external price shocks as an explanation. Hence, the roots of Danish output fluctuations are to be found
among domestic factors. Accordingly, the analysis does not carry over to an economy subject to large
external shocks.
The trough in 1981 had its origin in the very poor macroeconomic policies of the 1970s that can be
summarised as traditional Keynesian demand stimulus to the oil-price shocks. The sharp fall in
nominal interest rates following the announcement of the fixed-exchange-rate policy in 1982, in
combination with other austerity measures, was not accompanied by a corresponding immediate
reduction in inflation expectations. This led to a decline in expected ex-ante after-tax real interest rates
that triggered a boom in house prices and private consumption, leading to the peak in 1986. The until
then highly preferential tax treatment of interest-rate expenditures was reduced as from 1987. A
decline in actual inflation in combination with the tax changes led to a sharp increase in ex-post
after-tax real interest rates that triggered the proceeding depression in the housing market and a
strong increase in the private savings ratio. The Danish experience over the last twenty years is thus
that "home made" domestic shocks stemming from economic policy are more important than
exogenous external shocks.
Swedish krona and Danish krone vis-a-vis the euro Chart 4
SEK, DKK / EUR
7,0
7,5
8,0
8,5
9,0
9,5
10,0
10,5
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul
1999 2000 2001 2002
SEK DKK
The choice of exchange-rate regime is not a choice between a fixed nominal exchange rate and a
floating exchange rate that evolves according to purchasing power parity. A floating exchange rate
often moves relatively far away from any reasonable estimate of purchasing power parity and thus
acts as a shock creator rather than a shock absorber, cf. Buiter (2000). The strength of the dollar in
the mid-1980s and the present weakness of the euro are well-known examples. The importance of
such unwarranted disturb-ances is most severe for small open economies such as Denmark. The
exchange-rate movements depicted in Chart 4 and Chart 5 indicate that Sweden - a small open
economy with a floating exchange rate and low inflation - receives far more noise from exchange-rate
fluctuations than Denmark. The fixed-exchange-rate policy cannot ensure a stable nominal effective
exchange rate or a stable real effective exchange rate. However, the weight to the euro in the effective
Danish exchange rate is slightly below 60 per cent. Thereby, the fixed-exchange-rate policy yields a
nominal hedge in a very important market for the Danish economy. This planning stability is beneficial
to the business climate. A fixed-exchange-rate policy based on the nominal effective exchange rate
would not offer such a hedge against any specific currency.
Real effective exchange rate in Sweden and Denmark Chart 5
1980 = 100
110
105
100
95
90
85
80
75
70
65
60
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
Sweden Denmark
Note: The real effective krone rate is based on consumer prices. Most recent observation is
June 2002.
3. Monetary policy implementation and ERM II
The krone has remained close to the central parity against the euro since ERM II and the third stage of
the European Monetary Union came into operation on 1 January 1999, cf. Chart 6.
ERM II band and the Danish krone vis-à-vis the euro Chart 6
DKK/EUR
725
730
735
740
745
750
755
760
765
01-99 07-99 01-00 07-00 01-01 07-01 01-02 07-02
DKK/EUR Central rate Fluctuation band
In order to achieve exchange-rate stability, the interest rates of Danmarks Nationalbank are adjusted
in step with those of the ECB, with due consideration of conditions in the foreign-exchange market, cf.
Chart 7. A tend-ency for the krone to weaken will be met by a widening of the interest-rate differential,
and vice versa. Interventions in the foreign-exchange market are used to dampen fluctuations in the
krone rate.
Key monetary policy interest rates in Denmark and the euro area Chart 7
Per cent
6,0
5,5
5,0
4,5
4,0
3,5
3,0
2,5
2,0
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul
1999 2000 2001 2002
DK lending rate Euro main refinancing/minimum bid rate
Euro marginal rate in main refinancing operation
This implies that the decision-making body should be ready to take interest-rate decisions at more or
less any time, and therefore the structure of the decision-making process is quite different from that of
a central bank pursuing an inflation target. Moreover, the possibility of more or less real-time
evaluation of the success of Danmarks Nationalbank's monetary policy, i.e. whether the exchange rate
stays within the band, implies that there is no ambiguity with regard to fulfilment of the target.
Accordingly the word transparency implies something different under a fixed-exchange-rate system
compared to an inflation-targeting regime.
It is evident from Chart 6 that the exchange rate against the euro is far more stable than allowed by
the fluctuation band of +/-2.25 per cent against the euro. In the years preceding the breakdown of
ERM I in 1992-93 many exchange rates, including the krone, fluctuated widely within the narrow band,
while primarily the Dutch guilder, the Belgian franc and the Austrian schilling generally fluctuated little
within the bands. Obligatory intervention at the margin was not a rare event, and realignments
occurred frequently in some periods. Part of the explanation for these differences in exchange-rate
dynamics under the two arrangements may be a higher risk of contagion effects from other countries
under ERM I due to the parity grid in place. If, for example, macroeconomic developments in one
member state seemed to justify a realignment of its central parity in the ERM I, this tended to affect
financial market prices in other member states as well, reflecting expectations of further realignments.
In some cases this happened even though macroeconomic fundamentals did not seem to justify
realignments in other countries, see for example Favero and Giavazzi for an analysis of contagion
under ERM I. From a formal viewpoint there was no centre in ERM I, while ERM II consists of bilateral
agreements between the ECB and each participating central bank. Problems in one country are
therefore less likely to lead to problems for other countries. Of course, at the moment any contagion
within ERM II can be ruled out as Denmark is currently the only member!
The widening of the band to +/-15 per cent in 1993 was not considered meaningful as a basis for the
fixed-exchange-rate policy of Denmark. Consequently, Danmarks Nationalbank embarked on a
unilateral policy to stabilise the krone with the central parity as a point of reference - albeit from time to
time a distant point of reference. This policy brought the krone to a stable position close to the central
parity in early 1997. Since then, Danmarks Nationalbank's key interest rates have shadowed the
interest rates of the Bundesbank, and as of January 1999 the interest rates of ECB. In addition,
Danish interest rates have been changed unilaterally in periods with upward or downward pressure on
the krone and in periods of unrest in foreign-exchange markets. The most notable incidents in recent
years were in the autumn of 1998 in connection with the global financial turmoil and in the autumn of
2000 immediately after the referendum that rejected euro area membership.
It is crucial for the exchange-rate policy that Danmarks Nationalbank follows ECB rates automatically
without hesitation, irrespective of domestic considerations. Furthermore, the short-term interest rate
differential has to be increased promptly if the krone has a pronounced tendency to weaken beyond
the day-to-day fluctuations. Intervention in the foreign-exchange market cannot stand alone; but must
be accompanied by increases in interest rates. It is also an integral element of the foreign-exchange
defence that the interest-rate differential is increased quickly and substantially, but only reduced
gradually as a delayed response to currency inflows. This policy ensures that speculation against the
krone is costly and unprofitable.
The predominant role of long-term fixed-rate mortgages in Denmark reduces the tensions associated
with raising interest rates in order to defend the exchange rate. Furthermore, the monetary policy
instruments used by Danmarks Nationalbank allow for a differentiation of monetary-policy signals that
can ease the burden on "the man in the street" even further - at least in the short run. Commercial
banks have unlimited access to borrowing at Danmarks Nationalbank in the weekly operations for as
long as they have sufficient collateral. Danmarks Nationalbank's lending rate is thus the decisive
signal for money-market interest rates.For short periods it may be raised more aggressively than the
discount rate, which is the decisive rate for the general borrowing and deposit conditions at
commercial banks. See Christensen and Topp (1997) for a detailed account of the Danish
monetary-policy instruments and various liquidity measures that can be implemented in the event of
serious foreign-exchange unrest.
The fixed-exchange-rate policy and Danmarks Nationalbank's unconditional willingness to support the
exchange rate are firmly embedded among participants in the foreign-exchange market as well as
among Danish exporters and importers. The large commercial banks' speculative behaviour in the
foreign-exchange market acts as a stabiliser. If the krone lies on the weak side of the parity, the
commercial banks will position themselves in support of the krone, and they will furthermore advise
their customers to purchase krone e.g. sell export proceeds in foreign currency. The reverse is the
case if the krone is on the strong side of the central parity. All this takes place within a narrow range
around the central parity.
4. Conclusion
It is clear from the preceding sections that ERM II is not very visible in the day-to-day management of
the Danish fixed-exchange-rate policy.Danmarks Nationalbank seeks to stabilise the krone within a
much narrower range than the +/- 2.25 per cent fluctuation band. The ERM II band serves as a safety
net. It provides international support in a worst-case scenario. It is probably more important that by
entering the ERM II agreement in 1998 the Danish government strengthened its commitment to
pursue an economic policy in accordance with the requirements set by the fixed-exchange-rate policy.
A stability oriented macroeconomic framework conducive to growth and employment can undoubtedly
be achieved in many different ways. In the case of Denmark the fixed-exchange-rate policy and ERM
(I and II) membership have been instrumental to the establishment of such a framework. There are
many country-specific circumstances that make life either easy or difficult under a fixed-exchange-rate
regime. However, there are two fairly general lessons to be learnt. Firstly, monetary policy must be
unconditionally subordinated to the exchange rate. Secondly, a fixed-exchange-rate policy is neither
an approach by which lower interest rates can be achieved the easy way, nor a way to postpone
structural domestic adjustments with the support of the anchor country. The primary responsibility for
the establishment of a stability oriented macroeconomic framework remains with the individual country
itself.
Appendix
Chart 1A: Differential between main refinancing interest rates in Denmark and the euro area
Percent
7
6
5
4
3
2
1
0
apr-92 apr-93 apr-94 apr-95 apr-96 apr-97 apr-98 apr-99 apr-00 apr-01 apr-02
Interest rate differential
Note: Bundesbank main refinancing interest rate before 1999. Minimum bid rate from June 2000.
Source: Bundesbank, ECB and Danmarks Nationalbank.
Chart 2A: Interest-rate differentials between Denmark and Germany
Percent
12
10
8
6
4
2
0
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
10-year government bond yields 3-month interest rates
Source: EcoWin.
BIS Review 53/2002 9
Chart 3A: Breakdown of Danish exports on recipient countries
2001
Rest of world
25%
EFTA countries
7%
EU accession
countries
4%
Euro area
43%
Other EU
countries
21%
Source: Statistics Denmark.
Chart 4A: Monthly interventions by Danmarks Nationalbank, 1987-2002
Mill.USD
4000
3000
2000
1000
0
-1000
-2000
-3000
-4000
-5000
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
Net buying of foreign currency
Source: Danmarks Nationalbank.
10 BIS Review 53/2002