DP586 | Exchange Rate Policies for the EFTA Countries in the 1990s

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01/10/1991

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Abstract

As the European Community (EC) unifies its financial markets and fixes its exchange rates, the EFTA countries are liberalizing capital movements to the same extent. The EFTA countries thus face a decision on financial markets and exchange rate policy: should they essentially join the European Monetary System (EMS) or should they maintain independent currencies with alternative exchange rate policies? This paper begins by assuming that the EFTA countries align themselves with the EMS and join the unified European financial markets. We then review the constraints this decision would place on current account financing and on monetary policy. Then we question the assumption by introducing three alternatives: an active exchange rate policy that aims at price level stability, an alternative basket to the European Currency Unit (ECU) for a fixed peg, and gradual adjustment of the real exchange rate against the basket. We conclude that all three would be inferior to EMS membership.