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Discussing Euro Volatility

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This paper deals with Euro introduction and ask whether it is likely to increase the exchange rates volatility on a world-wide scale. Following this purpose, we present a three country-model (US, Germany and France) and compare the exchange rate volatility according to the nature of the shock (demand or supply shock) and to the exchange rate regime in Europe (flexible, EMS or EMU). Each country is represented by two authorities: a central bank and a government (a single central bank and two governments in Europe in the case of EMU). Within this framework, we compute Nash-equilibria. In theory, the exchange rate of a large closed country fluctuates more than the exchange rate of a small open country (the size effect), but results are ambiguous in the specific case of the Euro. An increase in volatility would only occur after demand and external supply shocks. Volatility would be reduced following internal supply shocks. The conclusions are the opposite if the sensitivity of intra-European trade to relative prices is particularly strong. In the case of common shocks in Europe, the excess of volatility would help economic stabilisation. As for asymmetric shocks (hitting only one country), the Euro would fluctuate less than the currency of the hit country in the previous monetary system (EMS), but this stability would harm economic stabilisation, as loss functions show. We note also that the independence of the ECB could lead to strong variations of the Euro after inflationary shocks if the ECB and European governments do not share the same inflation target. The constraints on fiscal policies which are induced by the Stability pact could make more active monetary policies necessary: these would be a source of instability for the Euro.

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Paper provided by Observatoire Francais des Conjonctures Economiques (OFCE) in its series Documents de Travail de l'OFCE with number 1998-03.

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Date of creation: 1998
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Publication status: published under the title " May the Euro Increase Exchange Rate Volatility? ", in T. Moser & B. Schips (eds.), EMU, Financial Markets and the World Economy, Kluwer Academic Publishers, October 2000.
Handle: RePEc:fce:doctra:9803

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  1. Leonardo Bartolini & Gordon M. Bodnar, 1996. "Are Exchange Rates Excessively Volatile? And What Does "Excessively Volatile" Mean, Anyway?," IMF Staff Papers, Palgrave Macmillan, vol. 43(1), pages 72-96, March.
  2. Cohen, Daniel, 1997. "How will the euro behave ?," CEPREMAP Working Papers (Couverture Orange) 9704, CEPREMAP.
  3. Henri Sterdyniak & Pierre Villa & Fabrice Capoen, 1994. "Indépendance des banques centrales, politiques monétaire et budgétaire : une approche stratégique," Revue de l'OFCE, Programme National Persée, vol. 50(1), pages 65-102.
  4. Y. K. Tse, 1998. "The conditional heteroscedasticity of the yen-dollar exchange rate," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 13(1), pages 49-55.
  5. Martin, Philippe, 1997. "The Exchange Rate Policy of the Euro: A Matter of Size?," CEPR Discussion Papers 1646, C.E.P.R. Discussion Papers.
  6. Henri Sterdyniak & Pierre Villa, 1993. "Régimes de change et coordination des politiques économiques en Europe," Revue de l'OFCE, Programme National Persée, vol. 43(1), pages 307-348.
  7. Pesaran, B & Robinson, G, 1993. "The European Exchange Rate Mechanism and the Volatility of the Sterling-Deutschemark Exchange Rate," Economic Journal, Royal Economic Society, vol. 103(421), pages 1418-31, November.
  8. Agnès Bénassy-Quéré & Benoît Mojon & Jean Pisani-Ferry, 1997. "The Euro and Exchange Rate Stability," Working Papers 1997-12, CEPII research center.
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