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Money Markets and Politics

A Study of European Financial Integration and Monetary Policy Options

Jens Forssbæck and Lars Oxelheim

The dramatic evolution of financial markets in the 1980s and 1990s, accompanied by increasing institutional integration between nations (most notably in the EU), have fostered a widespread belief that governments – particularly those of small economies – have essentially lost the power to pursue sovereign, independent economic policies. At the same time, it is widely assumed that the loss of monetary-policy control is a major opportunity cost for a country adopting a rigid exchange-rate regime or, in the European context, for countries joining the EMU This book sheds light on these arguments.
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Chapter 7: Monetary Policy Autonomy under Different Institutional Regimes

Jens Forssbæck and Lars Oxelheim


In this chapter, we investigate the third and final component in the ‘inconsistent trinity’ framework – that of monetary policy autonomy. This is done by way of analyzing international monetary policy transmission into our case countries. It is assumed that interest rates and monetary aggregates are the primary vehicles of policy (and hence the primary channels of transmission), and different approaches are taken to map out the basic interlinkages between policy variables of the 11 case countries and those of the larger benchmark economies. The general methodology used here has previously been used for similar purposes in the literature on monetary transmission and asymmetry within the European Monetary System (EMS). Most of this literature is concerned with a specific version of the hypothesis that some (smaller) countries’ monetary policies might be subordinated to the policies of other (larger) countries, namely the so-called German Dominance Hypothesis (GDH), and essentially attempts to answer the question if the EMS was a ‘Deutschmark area’.1 A number of studies focusing on the behavior only of interest rates, and covering primarily the 1980s,2 find various degrees of support for the hypothesis of German dominance, while others3 find that the EMS was essentially a symmetrically working system. Some studies4 devise models to assess the degree of autonomy in terms of more than a single variable (adding to interest rates primarily variables such as inflation rates and/or money supply growth). These studies tend generally to assert a ‘special role’, though not strict dominance, to Germany. Among the more...

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