Government Finance, Real Interest Rates and the European Monetary System

Abstract

At the beginning of the 1970s many theorists expressed a preference for ‘clean floating’. According to Kreuger ‘it must be noted that the economics profession was overwhelmingly of the view that flexible exchange rates would be vastly superior to fixed exchange rates’ (Kreuger, 1982, p. 4). This is now history. Recently, MacDonald summarized six theoretical arguments in favour of flexible exchange rates. None of them has fulfilled its promise since the breakdown of the Bretton Woods system in 1973 (MacDonald, 1988, p. 1–37). Theories of ‘clean floating’ are in general impractical and out of date. In this study we will distinguish between flexible, stable and fixed exchange rates. Flexible exchange rates are the result of supply and demand as these apply to currencies, with the possibility of clean and managed floating. Stable exchange rates are declared officially but are adjustable; revaluations and devaluations are possible. Fixed exchange rates are unchangeable. As far as the internal market of the European Economic Community in particular is concerned, a high degree of official exchange rate stability is desirable. A careful theoretical study by Van der Ploeg concludes rightly ‘that the completion of a common European market may be a prerequisite for full monetary union within Europe’ (Ploeg, van der, 1989, p. 51).