DP2633 | Why was the Euro Weak? Markets and Policies

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Against all odds, the euro turned out to be a weak currency. We argue that this outcome can readily be explained by the policy mix that was chosen at the onset of the period: tight fiscal policies following the convergence mechanism that was imposed by the Maastricht treaty and loose monetary policy that resulted from the convergence of interest rates to the lower point of the spectrum. We investigate this outcome empirically and show that the euro's weakness can be understood as the result of an excess supply in the zone, which is channelled abroad in the usual 'beggar thy neighbour? way. We also outline how an optimal policy mix could be set in the future and discuss a suggestion that has been made by Alessandra Casella on the proper way to determine the fiscal deficit of the zone.