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

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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