The main idea behind this paper is that sterling has strong affinities with both the Deutsche mark (now euro) and dollar, reflecting their importance for UK external business, though they have been obscured by regime changes and temporary influences. In principle the D-mark should show comparable affinities, but in its case they have been eroded by the long process of monetary integration in Europe, which has led to its 'polarisation' against the dollar, and thence high volatility in the DM/$ exchange rate. Thanks to sterling's split affinities, the impact of D-mark/dollar volatility on the UK economy has been cushioned by a tendency for movements in DM/£ and $/£ rates to be mutually offsetting, with the result that sterling's overall or effective rate is appreciably less volatile than either of its key bilateral rates. By joining EMU, the UK would escape exchange-rate volatility on trade with the euro zone but would suffer a marked increase in volatility on trade with the rest of the world - assuming that the euro proves at least as unstable as the D-mark against the dollar, and that the dollar is a representative currency for trade with ROW. Accordingly the net effect of EMU participation on UK effective-rate volatility would depend crucially on the relative weights of the euro zone and ROW in UK trade and payments, and on the relative volatility of the DM-euro and sterling against third currencies. Evidence is presented to show that the UK is significantly less integrated with the EU via current payments than via merchandise trade, and that the pound's affinity with the dollar has increased since the UK left the ERM. Counterfactual estimates are then made of prospective UK exchange-rate volatility by re-weighting the official UK effective rate index to reflect alternative assumptions about sterling's future. If sterling's experience since leaving the ERM is a guide to its future outside EMU (if it has one), and if the euro emulates the D-mark's volatility since that time, counterfactual comparisons suggest that joining EMU would reduce UK effective exchange-rate volatility by around two thirds on a trade-weighted basis, but by only a third or less on a payments-weighted basis, which arguably captures sterling's split affinities better.
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Paper provided by National Institute of Economic and Social Research in its series NIESR Discussion Papers with number
197.