The transition to floating exchange rates has induced an increased segmentation of international financial markets, which however was gradually reversed in the ensuing years. Since 1981 tighter monetary policy and high interest rates in the United States have maintained pressure on European interest rates; rather than fully aligning their interest rates, European countries have let the exchange rate take up part of the adjustment.
In Europe, since the inception of the EMS the DM has become the standard for monetary coordination, while at the same time increasing its role as a main dollar-substitute in international portfolios, with two consequences. First, the transmission within the EMS of external monetary shocks largely depends on the German monetary policy response. Second, for given other conditions, when the dollar strengthens vis-à-vis the DM, the latter weakens in the EMS, improving the system's cohesion; the opposite happens when the DM strengthens vis-à-vis the dollar.
This paper was prepared for the conference on "Europe and the Dollar" organized by Columbia University, M.I.T. and the Istituto San Paolo di Torino (Torino, June 4-5, 1984).
