Sterling, the Euro and the Dollar

In the period of floating exchange rates a distinct dollar—D-mark polarisation was noted, whereby periods of weakness for some European currencies relative to the dollar coincided with periods of strength relative to the Deutsche mark and vice versa. The relationship continued to be observed for those currencies such as sterling which remained outside the Exchange Rate Mechanism for most of the period. The observation, although more ‘an empirical regularity in search of a theory’ than a model (Buiter et al., 1998) seems reasonably robust; recently the dollar has fallen sharply against sterling while the euro has risen. An analysis of this relationship and its stability is important because it provides a guide as to how the euro might be expected to move against sterling as a part of any adjustment against the US dollar. In turn it sheds some light on the degree to which a dollar depreciation might affect Britain inside the Euro Area.