Exchange Rate Targeting in New Member States of the European Union: New Times, New Challenges

Author:Alina Georgeta Glod, Adina Criste, Iulia Lupu, Camelia Milea
Position:Financial and Monetary Research Centre 'Victor Slavescu', Bucharest - Financial and Monetary Research Centre 'Victor Slavescu', Bucharest - Financial and Monetary Research Centre 'Victor Slavescu', Bucharest - Financial and Monetary Research Centre 'Victor Slavescu', Bucharest
Pages:506-510
SUMMARY

This article points out some of the challenges of the monetary authorities in countries which have fixed exchange rate arrangement. In the current crisis environment, the Baltic States and Bulgaria seem to have more problems than solutions. Though, the situation is not very appealing now and in the future, they could exploit the status of being pegged to euro, by adhering sooner to the euro zone... (see full summary)

 
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Exchange rate targeting in New Member States
of the European Union: New Times, New Challenges
Alina Georgeta GLOD1, Adina CRISTE2, Iulia LUPU3, Camelia MILEA4
1Financial and Monetary Research Centre „Victor Slăvescu”, Bucharest, alina.glod@gmail.com
2Financial and Monetary Research Centre „Victor Slăvescu”, Bucharest, cristeadina@yahoo.com
3Financial and Monetary Research Centre „Victor Slăvescu”, Bucharest, iulia_lupu@ccfm.ince.ro
4Financial and Monetary Research Centre „Victor Slăvescu”, Bucharest, camigheorghe75@gmail.com
Abstract. This article points out some of th e challenges of the monetary authorities in countries which have fixed
exchange rate arrangement. In the current crisis environment, the Baltic States and Bulgaria seem to have more
problems than solutions. Though, the situation is not very appealing now and in the future, they could exploit the
status o f being p egged to euro, by ad hering sooner to the euro zone than the Visegrad Group if they urgently
correct the financial-budgetary and external imbalances.
Key words: monetary policy, crisis, exchange rate arrangement, convergence, inflation
1 Introduction
In general, national policies represent useful tools for modelling the (nominal) convergence process,
especially monetary policies which are solid adjustment instruments for the management of the most
important macroeconomic imbalances (e.g. inflation, exchange rate volatility). In this article we will focus
on a concrete analysis of the Baltic States and Bulgaria’s environment in which monetary policies operate
and the main problems faced by the monetary policies of these countries in pursuit of the nominal
convergence criteria.
As it is known, among the motivations underlying the exchange rate targeting in the Baltic States and
Bulgaria are: the high degree of openness of the economies and the small size of the Baltic countries. Both
require the choice of the exchange rate as a nominal target in monetary policy, using a strong currency as
anchor (e.g. deutsche mark, US dollar, recently euro) to reduce inflation and inflation expectations
(anchoring the internal inflation of the external one).
Under fixed exchange rate arrangement, the convergence of prices during the catching up process can only
take place through higher inflation in the New Member States (NMS). This idea is sustained by the
highest inflation rates during the 12-month period ending in April 2008 recorded by the three countries
pegging their currencies to the euro under currency board arrangement (Bulgaria, Estonia, and Lithuania)
and by Latvia, which maintains a conventional peg to the euro.
Besides the higher inflation associated with the real convergence process, there have been other factors
that have contributed to inflationary pressures in the Central and East European (CEE) countries with
fixed exchange rate. As long as the confidence in the sustainability of the fixed exchange rate remains
strong, domestic nominal interest rates tend to be at or close to euro interest rates. Since the convergence
effect pushed the inflation rate in the CEE countries with fixed exchange rate above the inflation rate in
the euro area, the domestic real interests have become very low or negative. This has led to credit booms
and overheating, putting further upward pressures on prices. In these circumstances, interest rates have
actually played a pro-cyclical role. The rapid growth of credit has also led to a very sharp increase in the
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