No. 328 - The Behaviour of the Dollar and Exchange Rates in Europe: Empirical Evidence and Possible Explanations

The analysis of the day-by-day evolution of currency markets often emphasises the relationship between the behaviour of the US dollar and that of the exchange rates between the other major currencies, in particular the tendency of EMS currencies to appreciate vis-à-vis the DM in periods of dollar strength. In this paper we systematically analyse this relationship. In particular, we examine the extent to which it has changed in the last ten years, a span of time that included a period without realignments in the EMS, the crisis of the System, the suspension of the lira’s participation in the ERM and the withdrawal of the pound, the “widened” band for the other currencies, and the re-entry of the lira. We also suggest a possible explanation for this relationship and find supporting empirical evidence for it: we show that the reactions of each bilateral exchange rate to shocks to the value of the dollar are related to the different orientation of monetary and exchange-rate policies in the various European countries, and that these differences are consistent with the potential effects of variations in the exchange rates vis-à-vis the dollar and the DM on each country’s rate of inflation.