An analysis of the
Mundell-Flemming-trilemma for the Euro-area
with regard
to the conventional monetary policy and the international exchange rate
policies
By Paul Schmidt
Matrikel-Nr. 986816
Supervisor: Lisardo Erman; Julian Meyer
Submitted on 23.06.2024
1 Introduction
In the recently released working paper “Towards a New Paradigm - the Inflation Shock as a Catalyst?” by Creel, Geerolf, Levasseur, Ragot and Sarenco they analyze the price dynamics in Europe from 2020 to the end of 2022. In this paper the determinants for the price dynamics are analyzed, the authors establish a causal chain between inflation and the positive changes in the prices of gas and electricity (cf. Creel et al., 2024, pp.10 - 12). The authors also highlight how inflation was counteracted with unorthodox fiscal measures. The indexation of pensions, price caps on goods and services or the Inflation Reduction Act (IRA) were cited as examples (cf. Creel et al., 2024, pp. 13ff.).In their paper, the authors show how fiscal policy interventions could also contribute to reducing inflation alongside conventional monetary policy interventions, therefore a fiscal could have been beneficial in terms of achieving the objective of price stability.The authors indirectly challenge the separation of monetary and fiscal policy. This separation of monetary and fiscal policy instruments becomes clear in the construction of the European Union and the United States. The individual member states of the European Union have fiscal autonomy within a certain framework, which is defined by a maximum budget deficit of 60% of gross domestic product (GDP) or the allocation of expenditure with regard to the Green Deal. Monetary decisions, on the other hand, are made by the European Central Bank (ECB), which pursues the goal of price stability. The main refinancing rate is used as one of the most important steering instruments in the short term (cf. Bpb, 2016). The federal reserve system (FED) of the United States has besides the target of price stability like the ECB also other targets, like the promotion of maximum employment (cf. FED, 2023). Both central banks have their flexible exchange rates in common and their dominant position in the international markets. Of course, the US dollar is still the dominant international currency, ahead of the euro, and it is not without reason that the so-called “dollar hegemony” has been talked about in the past.The fact that the US dollar is still the dominant global currency despite international disruptions is shown recently by the paper “De-dollarizaion? Not so fast” (2024) by Gerding and S.Hartley. To come back to the paper by Creel et al., why does the seperation paradigm exist, how have the currencies developed and what international effects do the currencies have?
The following sections will examine the causal relationships, the efficacy of conventional monetary policy, and the role of the euro and US dollar in bilateral trade relations. This analysis will focus on the euro as the primary currency of interest.
2 Impossible Trinity
The flexible exchange rates of the euro and the US dollar are linked to different conditions. A common theoretical framework is the impossible trinity, also called Mundell-Fleming trilemma.The described relationships of the trilemma go back to Mundell and Flemming, who described them at the same time in the 1960s (cf. Boughton, 2003). However, the first conception of the actual trilemma context goes back to Obstfeld, Shambaugh and Taylor. The following conception of the trilemma is based on their paper “THE TRILEMMA IN HISTORY: TRADEOFFS AMONG EXCHANGE RATES, MONETARY POLICIES, AND CAPITAL MOBILITY” (2004). The impossible trinity puts free capital mobility between countries, the type of exchange rate policy and the independence of monetary policy from state intervention in a relation. If all three of these policies are implemented, arbitrage profits are generated and these must be avoided. This is an impossible trinity, as not all three are possible at the same time. According to Ostrom (1990) p. 281ff. there are therefore three possibilities:
A country fixes exchange rate or has free capital flows, without an independent monetary policy,
An independent monetary policy and free capital flows, without a fixed exchange rate,
A fixed exchange rate and an independent monetary policy with capital controls.
The Euro Area opted for option (a) with the introduction of full capital mobility in the 1990s, which meant the introduction of a central bank with an independent monetary policy. Independence of the central bank means that monetary policy decisions are not done by the government, but instead of an independent from the government acting central bank. So if the Euro Area had not an independent central bank, therefore an autonomous monetary by governments controlled monetary policy, the interest rate fluctuations would create currency arbitrage. In this classic model, however, the distributive differences among households are not implied, but these do have an impact on aggregate demand and indirectly on the aggregate supply of goods and services, i.e. also indirectly on the credit and money market through the IS curve relationship. In connection with sustainability and redistribution as policy goals, the study by Creel et al. (2024) cited at the beginning points out that the current monetary policy, which follows the Tinbergen principle, was not sufficient during the period from 2020 to the end of 2022 in achieving the goal of ECB of price stability.
3 Empirical Analysis
In the following sections, the focus is on empirical analyses based on data from the OECD, IMF, Eurostat and the FED.
3.1 Interest rate developments of the Euro area
The Impossible Trinity can be derived theoretically from the IS and MP curves and the interest rate parity condition (IRP). For the Impossible Trinity to be reliable, the assumptions of the IS and MP curves and the IRP must apply. For the functionality of the Euro as a currency the management of the central bank with conventional and unconventional monetary policy controls is of high importance and a necessity for the system. The main monetary policy instrument used in the past were the short term main refinancing operations (MRO). They describe the interest rate to which banks can borrow money in the short term (cf. ECB, 2018). In the following Figures is besides the short-term MRO (blue) also the passing on of the short term interest rate on the money market (red).
Unsurprisingly, the two time series in Figure 1 are relatively synchronous. Figure 2 shows the money market rate relative to the euro, i.e. if the value in Figure 2 is positive, the money market rate is higher than the short-term MRO rate.In particular, Figure 2 shows the increased differences during the financial and euro crisis and at the beginning of 2022. The observed a positive average ratio in Figure 2 can be attributed to the fact that commercial banks tend to incur losses when operating with negative ratios. The observed discrepancies can be attributed to the prevailing economic crises, while the observed zero-convergence can be attributed to the corresponding market pressures in the money market. This convergence can be observed in the period between the crises, 2013 to 2021.
3.1.1 IS curve and MP curve for the Euro
As previously stated, a portion of the impossible trinities can be derived from the IS curve, which illustrates the inverse relationship between the interest rate and the overall economic output. The IS curve describes the relationship between the interest rate and overall economic output. In this model, investment has a key function: at a low interest rate, it is cheap for private companies to take out loans, which increases investment and overall economic output. At a high interest rate, investments are correspondingly more expensive, as the interest rate is calculated against the marginal profit. For this reason, overall economic output decreases as the interest rate rises. In the following Figures, the overall economic output is represented by GDP indexed to 2010 and the interest rate by the short-term MRO.
Figure 3 shows that the ratio of short-term MRO to GDP converges close to zero, as this corresponds to the assumption of the IS curve. In 2013 to 2014, the zero lower bound (ZLB) appears to have been reached as the lowest possible interest rate, until the effective lower bound (ELB) was reached by 2016 and 2017. The ELB describes the point at which a further reduction in interest rates by the central bank no longer stimulates economic growth. The ZLB was the previously assumed concept that this point would be reached at zero interest rates, the ELB includes the possibility of negative interest rates. The reaching the ELB also implies an end to the effectiveness of conventional monetary policy.This restricts the central bank’s scope for action and leads to the use of unconventional monetary policy. Figure 4 demonstrates the inverse relationship of the IS curve between interest rate and economic output. The distribution of observations varies over time.
In addition to the IS curve, the so-called MP curve is taken as the basic assumption for the impossible trinity.The MP curve is the central bank’s reaction to rapidly growing economic output. The central bank increases the money supply accordingly in order to keep the economy growing within a constant framework. The MP curve thus describes a positive relationship. In the following figures, the marginal money supply M3, which accordingly comprises the eurozone’s money supply at all liquidity levels, is set in relation to the marginal indexed GDP in 2010.In the second figure, the data points for the observation of Q2 and Q3 2020 were removed as outliers.
In the time series of Figure 5, the marginal money supply M3 appears to be much more volatile than the marginal GDP, although this may also simply be due to the respective number and collection of data. A synchronous dynamic can be discerned here, but not the nature of the correlation. Figure 6 shows the correlation between the two variables and reveals a negative correlation. In addition, Figure 6, similar to Figure 4, shows a distributive difference with regard to the time of the data point. Starting with Figure 1, at least three different time periods can be identified. Firstly, until the financial crisis, followed by a relatively steady period after the financial and euro crisis until the start of the Coronavirus pandemic, which then describes the start of the third period. In the following, the data was divided into three periods, up to 2009, from 2010 to 2019 and from 2020.
Figure 7 shows heterogeneous dynamics. The two crisis periods, up to 2009 and from 2020, show a positive correlation between GDP and MSP, contrary to the general correlation in Figure 4 and the correlation assumed by the IS curve. The crisis-free period from 2010 to 2019 shows to a certain extent the normal state of the IS curve, the market reacts to the central bank’s interest rate policy. During periods of crisis, GDP, which is used here as a variable for macroeconomic output, also reacts to other factors that are then determinants of GDP development. Figure 8 shows similar dynamics. A constant to slightly negative dynamic can be seen for the first period. Similar to the first period of Figure 7, the crisis may simply be the determining factor for this differentiating correlation in contrast to that of Figure 6. A clear positive correlation can be seen in the second and final period. In the final period, a outliers were addressed and rectified, this could lead eventually to a different result.
In order to verify the assumption regarding other determinants during the crisis periods, it is important to compile a complete picture of the relevant economic factors. The examined correlations of the IS and MP curves become clear in real terms via the investments and debt taken on, as borrowed capital is cheap at low interest rates and therefore the investments increase.For this reason, investments within the EU as a whole and investments over the last 20 years are presented here. Private sector debt is also of interest, as it shows directly when borrowed capital becomes cheaper.
Figure 9 shows that investments, both overall and in the private sector, are relatively constant as a proportion of GDP. The greatest dynamic can be seen in reaction to the 2008 financial crisis, after which the share of both private and total investment fell. However, the other dynamics in the share of GDP are relatively marginal. Figure 10 shows how the indexed debt of the private sector rose constantly with GDP after 2000. In addition, during the financial crisis and the coronavirus pandemic, the opposite trend can be seen in relation to GDP. After the financial crisis, debt falls steadily, with the exception of the coronavirus pandemic. In Figure 9, dynamics can be guessed at, but a further representation in the inform of the marginal values is necessary to visualize this better. In order to capture the assumed relationship between investment and the central bank’s monetary policy, the marginal money supply M3 (light blue) from Figure 6 and the marginal short-term MRO (dark blue) are linked to the two investment variables, the marginal total investment in relation to GDP (dark red) and the marginal private investment in relation to GDP (dark violet).
The marginal investment and the marginal money supply (M3) exhibit a synchronous movement, with the money supply lagging behind changes in investment by a period of one to two time periods. This makes intuitive sense, as the money supply increases due to investments. The interpretation of the marginal short-term MRO is more difficult, however, as the fluctuations and frequency of the data are significantly higher. It can be interpreted that the significant reduction heralds the increase in investments in GDP, but this is more in the form of a temporary reaction spectrum, with investments reaching their maximum positive change at the end of 2015, while the short-term MRO remained unchanged.This can be interpreted as an indicator that the EFA has been reached.
3.2 The ELB and the functionality of the short-term MRO as an monetary policy instrument
As described above, reaching the ELB is problematic as it limits the effectiveness of conventional monetary policy. In the recently published paper “The open-economy ELB: Contractionary monetary easing and the trilemma” by Cavallion and Sandri (2023), it is claimed that certain circumstances the consistency of impossible trinity may not be guaranteed when approaching the ELB. Under the authors implications the free movement of capital in combination with flexible exchange rates can make it difficult to realize monetary independence. Various dimensions are relevant in the analysis carried out by Cavallion and Sandri. These include the proximity to the ELB and the negative change in international liquidity, this tightening of liquidity may lead to increase of the ELB and therefore leading to an decrease in the central banks monetary control possibilities. The exchange rate and capital inflows, i.e. foregin direct ivestments (FDI), are also relevant. This is because when the economy is close to the ELB, it is increasingly dependent on foreign investment. This relationship, which is triggered by proximity to the ELB, can be illustrated by the determinants of the difference in the marginal performance of the domestic economy and the global economy. The following regressions examine the extent to which there is evidence for Euro area for the dissolution of the impossible trinity relationship due to the achievement of the ELB. The endogenous variable represents the difference between the change in the marginal nominal GDP of the Euro area and the marginal nominal GDP of the global economy. The exogenous variables are international investment in the EU, flexible exchange rates, the ECB’s main refinancing rate and the marginal interest rate realized by commercial banks. The last of the exogenous variables has the highest significance, while the other exogenous variables serve as control variables. Three time periods are analyzed. Firstly, the entire time period from 2004 to 2022, then from 2004 to 2012 and finally from 2012 to 2022. This distinction between the time periods is due to the heterogeneous dynamics of the different periods, which have already been shown in the IS and MP curve analysis.
##
## Table 1: regressions for different periods
## =======================================================================================================================
## Difference between the marginal Eu GDP and the marginal world GDP mEUmINT mEUmINT
## Period 2004-2022 Period 2004-2012 Period 2013-2022
## (1) (2) (3)
## -----------------------------------------------------------------------------------------------------------------------
## mM2int -0.04
## (0.13)
##
## mFDIEU -0.01*
## (0.004)
##
## mNomEx 0.17
## (0.16)
##
## EuroYield1 -0.01
## (0.005)
##
## mmoneyyield -0.02***
## (0.003)
##
## mM2int -0.33
## (0.56)
##
## mFDIEU 0.01
## (0.04)
##
## mNomEx -0.08
## (0.39)
##
## EuroYield1 0.003
## (0.01)
##
## mmoneyyield -0.04
## (0.03)
##
## mM2int 0.03
## (0.15)
##
## mFDIEU -0.01
## (0.004)
##
## mNomEx 0.10
## (0.27)
##
## EuroYield1 0.01
## (0.01)
##
## mmoneyyield -0.01**
## (0.004)
##
## Constant -0.13 0.38 -0.12
## (0.20) (0.73) (0.27)
##
## N 19 9 10
## R2 0.70 0.45 0.82
## Adjusted R2 0.59 -0.46 0.60
## Residual Std. Error 0.03 (df = 13) 0.04 (df = 3) 0.03 (df = 4)
## F Statistic 6.16*** (df = 5; 13) 0.49 (df = 5; 3) 3.69 (df = 5; 4)
## =======================================================================================================================
## Notes: ***Significant at the 1 percent level.
## **Significant at the 5 percent level.
## *Significant at the 10 percent level.
##
## Table 1: regressions for different periods
## -
##
## =
##
## Table 1: regressions for different periods
## -
##
## =For the entire period and for the period from 2012 to 2022, the marginal money yield can be seen as significant for the difference between the marginal GDP of the euro zone and the marginal GDP of the world, which indicates the functionality of the euro system. The case described by Cavallion and Sandri does not seem to apply to the euro area, although further analysis is of course needed to analyze the euro specifically in terms of functionality and crisis resilience. The euro area is a special case, as the euro is also subject to a certain flexible exchange rate. On the one hand, the euro is loosely linked to the US dollar, as the dollar is still by far the dominant global currency, but the euro is the second most important currency, the decisive factor for this clear positioning being the financial crises of 2008 to 2014, even if these originated in the USA (cf. Beckmann et al., 2020). Furthermore, the Exchange Rate Mechanism (ERM II) for non-euro EU states provides for regulated center exchange rates, of which a flexibility of +/-15% is possible (cf. European Commission, 2024). For this reason, it is a special case compared to other currencies.
3.3 Exchange rates and the purchasing power parity
The study by Cavallion and Sandri also differentiates between different economies and describes that, particularly in the case of emerging economies, the functionality of flexible exchange rates is limited if they are close to the ELB. In addition, this mechanism, which is described in the study, leads to an exchange rate that is not aligned with purchasing power, which is particularly significant in developing economies. The difference between the exchange rate and purchasing power is particularly high when the ELB is reached and the interest rate is increasingly controlled by capital imports. First, the differences between the nominal exchange rates and the purchasing power to GDP of different economies are shown from the perspective of the euro and the USD using two world maps for the last 20 years.
Figure 12 and 13
Figure 12 and 13
The values shown represent whether the flexible exchange rate is too low or too high in relation to purchasing power. This was calculated as follows:
(Exchange Rate / Purchasing power parity) - 1.
The interpretation is as follows:
0 > The exchange rate is too low, the national currency is undervalued, 0 = The exchange rate corresponds exactly to the purchasing power, 0 < The exchange rate is too high, the national currency is overvalued.
The data acquisition proved to be very time-consuming, as the data used came from different data sources. The data for the USD exchange rates of the countries Hong Kong, Albania, Bulgaria, Cabo, Verde, Cameroon, Georgia, Madagascar, North Macedonia, Singapore, Morocco, Senegal and Serbia are not based on the averages, like the exchange rate data for the other countries included, but on spot exchange rates at the first of the year. The data for the nominal exchange rates were obtained from Eurostat; these are annual averages. Detailed data on the purchasing power of the respective country are for the most part only recorded in relation to USD 1, so the exchange rate purchasing power dynamics were calculated as follows:
\[ \left(\frac{Ex_{€}}{PPP_{USD} \times Ex_{\frac{USD}{€}} \times \frac{Ex_{\frac{€}{USD}}}{PPP_{€}}}\right) - 1 \] .
The exchange rate of one euro to the corresponding foreign currency is divided by the purchasing power in US dollars. The US dollar purchasing power is multiplied by the exchange rate from one US dollar to one euro. However, this exchange rate from one USD to the euro is nominal and not exact due to the differences already shown, so it is adjusted for this difference and multiplied by the difference, i.e. the exchange rate from the euro to the dollar is divided by the purchasing power of the euro countries at the corresponding point in time. Finally, the result is subtracted by 1. This is only done to make the interpretation more intuitive, as undervalued currencies have a negative sign and overvalued currencies have a positive sign.
The following animation shows the development of exchange rates over time.
Although there are general tendencies of constantly over- and undervalued economies, as in the case of Indonesia or India, there are also dynamics of constant appreciation and depreciation over time, as in the case of Sweden. This is related to various factors, such as marginal purchasing power or inflation or deflation. The purchasing power/exchange rate dynamic cannot be considered exclusively endogenous, but also exogenous. For example, an undervalued domestic currency can lead to more exports and fewer imports, as domestic products become cheaper compared to those abroad. The opposite dynamic is possible with an appreciation of the domestic currency.A negative relationship between the exchange rate/purchasing power ratio and the export/import ratio (exports/imports) can therefore be assumed. Secondly, on the basis of the optimum currency area theory (OCA), it can be assumed that countries with increased trade volumes are convergent to the traded currency. On the basis of this correlation of the increased economic linkage of the increased volume of traded money, a purchasing power/exchange rate ratio closer to 0 can be assumed with increasing trade volumes. These two assumptions can be examined with the following graphics.
Evidence can be derived here for both assumptions. The negative correlation of the first assumption can be derived in particular for Asian, Middle Eastern and African countries with lower absolute trade volumes. For European and North American countries, a relatively constant dynamic can be derived for high trade volumes. This could speak in favor of the second assumption.These relationships are now examined using linear regression. The basic regression model contains the purchasing power/exchange rate ratio as an endogenous variable and the export/import ratio and the absolute trade volume as two exogenous variables. In the “with region” regression, the affiliation to a specific geographical region is included, as differentiating dynamics between the various regions could be observed in the previous figures. In the “with region and year” regression, the corresponding year is included as a control variable in the regression equation as an exogenous variable in addition to the regional affiliation. evidence can be derived here for both assumptions. The negative correlation of the first assumption can be derived in particular for Asian, Middle Eastern and African countries with lower absolute trade volumes. For European and North American countries, a relatively constant dynamic can be derived for high trade volumes. This could speak in favor of the second assumption.
| Table.2 | Baseregression | with.region | with.region.and.year |
|---|---|---|---|
| R^2 | 0.0845 | 0.2162 | 0.2142 |
| AIC | 2467.1540 | 2332.4970 | 2349.3120 |
| BIC | 2486.5030 | 2376.0330 | 2499.2690 |
When comparing the models, it is noticeable that after AIC and BIC, the model that has the corresponding region as an additional exogenous variable has the best fit. On further examination, only the years 2004 and 2006, after the introduction of the euro, can be classified as significant at the significance level of 5% in the “with region and month” regression equation.
##
## Table 3: regressions with regions and year
## ========================================================================================
## Exchange rate-PPP-ratio
## Baseregression with regions with regions and years
## (1) (2) (3)
## ----------------------------------------------------------------------------------------
## reEUtrade -0.04*** -0.06*** -0.06***
## (0.01) (0.01) (0.01)
##
## absEUtrade -0.0000*** -0.0000*** -0.0000***
## (0.0000) (0.0000) (0.0000)
##
## regionEurope -0.50*** -0.50***
## (0.08) (0.08)
##
## regionMiddle East Africa 0.09
## (0.09) (0.09)
##
## regionNorth America -0.75*** -0.76***
## (0.12) (0.12)
##
## regionOceania -1.26*** -1.26***
## (0.14) (0.14)
##
## regionSouth America -0.43*** -0.42***
## (0.10) (0.10)
##
## year2001 0.04
## (0.19)
##
## year2002 0.13
## (0.19)
##
## year2003 0.32*
## (0.19)
##
## year2004 0.42**
## (0.19)
##
## year2005 0.38**
## (0.19)
##
## year2006 0.31*
## (0.19)
##
## year2007 0.32*
## (0.19)
##
## year2008 0.29
## (0.19)
##
## year2009 0.31
## (0.19)
##
## year2010 0.14
## (0.19)
##
## year2011 0.11
## (0.19)
##
## year2012 0.02
## (0.19)
##
## year2013 0.05
## (0.19)
##
## year2014 0.07
## (0.19)
##
## year2015 -0.03
## (0.19)
##
## year2016 -0.04
## (0.19)
##
## year2017 -0.02
## (0.19)
##
## year2018 0.05
## (0.19)
##
## year2019 0.003
## (0.19)
##
## year2020 0.09
## (0.19)
##
## year2021 0.13
## (0.19)
##
## year2022 0.01
## (0.19)
##
## Constant 1.00*** 1.34*** 1.19***
## (0.04) (0.07) (0.15)
##
## N 932 932 932
## R2 0.08 0.22 0.24
## Adjusted R2 0.08 0.21 0.21
## Residual Std. Error 0.91 (df = 929) 0.84 (df = 924) 0.84 (df = 902)
## F Statistic 42.90*** (df = 2; 929) 36.40*** (df = 7; 924) 9.75*** (df = 29; 902)
## ========================================================================================
## Notes: ***Significant at the 1 percent level.
## **Significant at the 5 percent level.
## *Significant at the 10 percent level.The export/import ratio and the absolute trade volume are significant in all three regressions at the 1% significance level The geographical region is significant with the exception of “Middle East & Africa”, but this is simply due to the categorization, as economically heterogeneous countries are combined here. In addition, none of the years between 2013 and 2018 are significant, which speaks for the functionality of the ECB’s monetary policy and indirectly confirms the results of the regression on EU GDP. The study by Cavaillon and Sandri (2023) establishes the connection between the achievement of the ELB and a price policy controlled by trade, especially for economies with a capital-labor ratio. This dynamic can be described in terms of a negative relationship between the exchange rate-purchasing power ratio and the export-import ratio. The result of this negative correlation is an increased control of domestic price dynamics by external capital imports.
3.4 Differences in exchange rate regimes
This correlation is also reflected in the type of exchange rate policy. Based on the “Annual report on EXCHANGE ARRANGEMENTS AND EXCHANGE RESTRICTIONS” from the International Monetary Found of 2022 for the year 2021, exchange rate policies can be classified into four categories:
Floating regimes, describes exchange rates that adjust to the corresponding market conditions,
Soft pegs, describes exchange rates that follow one or a handful of foreign currencies at a fixed rate,
Hard pegs, describes fixed exchange rates,
Residual, describes exchange rates that are also based on other currencies as a reference, but leave the central bank free to intervene.
The residual category also includes other heterogeneous exchange rate mechanisms. In addition, such a categorization is very generalizing here in particular, but the reduction of information helps to better grasp the systemetics in this case. The following visualizes how the differentiating exchange rate regimes are allocated geographically.
Figure 18
It is noteworthy that floating regimes and soft pegs are particularly well represented in this context. The advantages of flexible regimes are evident in their adaptability and regime feasibility, as the credibility and independence of the central bank is guaranteed. According to Coles and Philippopoulos (1999), the effectiveness of soft peg regimes depends on the role of the center country. The center currency must be price-stable and also reliable for regimes such as soft peg, i.e. a bounded exchange rate policy, to function efficiently. In the following are the different exchange rates of national currencies to special drawing rights (SDR), which is a value of basket for currencies, displayed.
The plot shows how the different bounded currencies constantly follow the euro or the US dollar. This is because these are relatively constant currencies and are therefore effective as center currencies.
The floating regimes can also be found with an higher probability in OECD countries and nominally larger economies, the GDP per capita, that are synchronized with economies with high absolute trade volumes with the Eurozone, i.e. also those that have a more constant exchange rate/purchasing power ratio and export/import ratio. Conversely, countries that do not have a floating regime also appear to be those that have negative exchange rate-purchasing power ratios and export-import ratios. To follow up on this impression, the data is visualized in the following plot, with the floating regims marked in red, the soft pegs in blue and the hard pegs in blue.
The lower exchange rate/purchasing power ratio for floating regimes is unsurprising, as nominal exchange rates adjust to the market situation with greater frequency, which is also the causal relationship of flexible exchange rates in the impossible trilemma. An increased trade volume also appears to lead to a decreasing exchange rate/purchasing power ratio, which applies to floating regims and soft pegs and is in line with the assumptions made so far. In the case of the export-import ratio, it can be seen that in countries with an EU soft peg exchange rate policy, more is exported than imported, and an overvaluation of the corresponding currency is conclusive. Accordingly, it is also striking that with a lower export-import ratio, the corresponding currency is also valued lower.
However, even with floating regimes, the adjustment of exchange rates to international prices does not have to be perfect. For example, the paper “Invoicing Currency and Symmetric Pass-Through of Exchange Rates and Tariffs: Evidence from Malawian Imports from the EU” (2022) by Montfaucon analyzes how the exchange rate passthrough (ERPT) of the bilateral exchange rates for the U.S. dollar and the euro can differ for the country of Malawi. In the bilateral exchange rate development of the euro, the assumed symmetry of prices is not guaranteed by the low ERPT. This is problematic considering that Malawi is an import-dependent country and has a floating regime as its exchange rate policy. The exchange rate/purchasing power ratio can also have an influence on the probability that the type of the exchange rate regime changes. The paper of Tamgac (2013) suggests that if countries with a pegged regime, here labeled as soft peg and hard peg, an increase in the misalignment in the exchange rates have a decreasing influence in the regimes durability.
4 Conclusion
Overall, the separation paradigm, to return to the study by Creel et al. mentioned at the beginning, has been confirmed with regard to currency stability. This is demonstrated by the role of the euro as a center-currency and by adjusting export and import dynamics for over- and undervalued currencies. It always makes sense to reconsider the effects of monetary policy, especially in times of crisis, theoretical assumptions quickly become invalid, as could be seen in the reproduction of the theoretical IS-MP correlations. Internationally, it will be a challenge to improve the efficiency of exchange rate passthrough (ERPT) for soft peg currencies against the US dollar and other currencies, as it can be seen that these have an increased exchange rate-purchasing power differential in relation to the bilateral euro exchange rates. Although these increased differences go hand in hand with lower trade volumes, these countries are nevertheless a good indicator of which currency will prevail in case of doubt. It is therefore also necessary to reconsider the separation parafigm according to the Tinbergen principle, especially under the simultaneous implementation of the IRA.
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Declaration of Honour
I hereby certify that I have prepared this Seminar Paper independently and without the use of aids and sources other than those indicated, and that I have marked as such the passages taken verbatim or in spirit from the sources used.
