THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 558

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PA R T V I

International Finance and Monetary Policy

The Euro s Challenge to the U.S. Dollar

GLOBAL

With the creation of the European Monetary
Union and the euro in 1999, the U.S. dollar
is facing a challenge to its position as the
key reserve currency in international financial transactions. Adoption of the euro
increases integration of Europe s financial
markets, which could help them rival those
in the United States. The resulting increase
in the use of euros in financial markets will
make it more likely that international transactions are carried out in the euro. The economic clout of the European Union rivals
that of the United States; both have a similar
share of world GDP (around 20%) and world
exports (around 15%). If the European

Central Bank can make sure that inflation
remains low so that the euro becomes a
sound currency, this should bode well for
the euro.
However, for the euro to eat into the
U.S. dollar s position as a reserve currency,
the European Union must function as a cohesive political entity that can exert its influence
on the world stage. There are serious doubts

on this score, however, particularly with the
no votes on the European constitution by
France and the Netherlands in 2005, and most
analysts think it will be a long time before the
euro beats out the U.S. dollar in international
financial transactions.

The fixed exchange rate dictated by the Bretton Woods system was abandoned
in 1971. From 1979 to 1990, however, the European Union instituted among its
members a fixed exchange rate system, the European Monetary System (EMS). In
the exchange rate mechanism (ERM) in this system, the exchange rate between
any pair of currencies of the participating countries was not supposed to fluctuate
outside narrow limits, called the snake. In practice, all of the countries in the EMS
pegged their currencies to the German mark.

How a Fixed
Exchange Rate
Regime Works

Figure 20-2 shows how a fixed exchange rate regime works in practice by using
the supply and demand analysis of the foreign exchange market we learned
in the previous chapter. Panel (a) describes a situation in which the domestic
currency is fixed relative to an anchor currency at Epar, while the demand curve
has shifted left to D1, perhaps because foreign interest rates have risen, thereby
lowering the relative expected return of domestic assets. At Epar, the exchange
rate is now overvalued: The demand curve D1 intersects the supply curve at an
exchange rate E1, which is lower than the fixed (par) value of the exchange rate
Epar. To keep the exchange rate at Epar, the central bank must intervene in the
foreign exchange market to purchase domestic currency by selling foreign
assets. This action, like an open market sale, means that both the monetary base

and the money supply decline, driving up the interest rate on domestic assets,
i D.6 This increase in the domestic interest rate raises the relative expected return
on domestic assets, shifting the demand curve to the right. The central bank will
continue purchasing domestic currency until the demand curve reaches D2 and
the equilibrium exchange rate is at Epar at point 2 in panel (a).
6

Because the exchange rate will continue to be fixed at Epar, the expected future exchange rate remains
unchanged and so does not need to be addressed in the analysis.