THE IMPACT OF EURO STRENGTHENING ON THE EMU

ECONOMY : A REVIEW

Being a Dissertation presented in part of requirement for the Bachelor of Arts in

International Business and Management Studies, School of Economics, INHOLLAND
University, Diemen, The Netherlands
“This work or any part thereof has not previously been presented in any
form to the Hogeschool Holland or to any other institutional body whether
for assessment or other purposes. Save for any express acknowledgments,
references and/or bibliographies cited in this work, I confirm that the
intellectual content is the result of my own efforts and no other person”

________________________
Jenny Setiawan

2
 ACKNOWLEDGEMENT

This dissertation has been written as final requirement for achieving the Bachelor or Arts in

International Business and Management Studies at INHOLLAND University.

I would like to express my gratitude to several people without whom this dissertation cannot be

actualized the way it did. First, I am grateful for David Wilson for his commitment, guidance,

and support throughout the process and for not only being my dissertation supervisor but also my

motivator. Marinella Kramer de Moya, as my second marker, for his availability and enthusiasm

in my dissertation. Keith Medhurst, for his genuine support and inspiring conversations. Next, I

would like to thank my Business Research Methods lecturer, Menno van Voortuizen, for his

knowledge in his area that has saved me from reading over adequate information. Rene van der

Linden, the European Business Environment lecturer, for his expertise and directions in

orchestrating the economic issues related to my dissertation.

Thank you all!

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 CONTENTS

ACKNOWLEDGEMENT...............................................................................................................3
CONTENTS...................................................................................................................................4
LIST OF CHARTS AND TABLES.................................................................................................6
GLOSSARY...................................................................................................................................7
EXECUTIVE SUMMARY...........................................................................................................10
1.RESEARCH AIMS.............................................................................................................................12
1.1 Research Questions.....................................................................................................12
1.2 Significance of Research..............................................................................................13
1.3. Methodology.............................................................................................................13
1.4. Dissertation Framework..............................................................................................13
1.5. Limitation.................................................................................................................14
2.INTRODUCTION...............................................................................................................................16
2.1. Integration economy and monetary in Europe.................................................................17
2.2. Deterioration of US economy.......................................................................................17
2.3. Real Interest Rate Differentials.....................................................................................18
2.4. Emerging Asian Countries...........................................................................................19
3.RELATIONSHIP OF EURO AND THE EMU ECONOMY............................................................20
3.1. Inflation....................................................................................................................21
3.2. Interest rate................................................................................................................21
3.3. Money Supply............................................................................................................21
3.4. Trade Balance............................................................................................................22
3.5. Gross Domestic Product..............................................................................................22
Is the Euro “overvalued”?..................................................................................................22
4.THE EFFECTS OF EURO STRENGTHENING TO EMU ECONOMY.........................................25
5.POLICIES TO ADJUST MACROECONOMIC ISSUES CAUSED BY EURO STREGHTENING
................................................................................................................................................................28
5.1 Monetary Policy..........................................................................................................29
5.2. Discretionary Fiscal Policy..........................................................................................31
5.3. Sterilised Intervention Policy.......................................................................................34
5.4. Recommendation to EMU...........................................................................................36

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6. CONCLUSION.........................................................................................................................38
BIBLIOGRAPHY.........................................................................................................................39

5
 LIST OF CHARTS AND TABLES

Charts:

Chart 1 Detailed Methodology……………………………………………………………..14

Chart 2 Euro-dollar Development………………………………………………………….15

Chart 3 EMU vs. US Interest Rate………………………………………………………….18

Chart 4 World Real GDP Growth…………………………………………………………..19

Chart 5 Euro/dollar: nominal exchange rate and PPP……………………………….……..23

Chart 6 Demand Shift in EMU and US……………………………………………………25

Chart 7 Euro Area Indices of Consumer Prices……………………………………………26

Chart 8 Expansionary Monetary Policy Mechanism………………………………………28

Chart 9 Contractionary Fiscal Policy Mechanism…………………………………………31

_____________________________________________________________________________

Table:

Table 1 The Big Mac Index………………………………………………………………. 23

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 GLOSSARY

Aggregate Demand : total spending on goods and services made in the economy. (Sloman
and Hinde, 2007)

Aggregate Supply : the total amount of output in the economy (Sloman and Hinde, 2007)

Balance of Payment : the value of all transactions between a country’s residents and the rest
of the world (Rugman, 2006)

Budget Deficit : the excess of central government’s spending over its tax receipt (Sloman and
Hinde, 2007)

CPI : Consumer Price Index, economic indicators constructed to measure the changes over
time in the prices of consumer goods and services
acquired, used or paid for by households. (Eurostat)

Deflation : a period of falling prices; negative inflation (Sloman and Hinde, 2007)

ECB : European Central Bank

EMU :European economic and Monetary Union , the process of harmonising the economic
and monetary policies of the Member States of the
Union with a view to the introduction of a single
currency, the euro (EUROPA.)

Equilibrium : a position of balance. A position from which there is no inherent tendency to

move away (Sloman and Hinde, 2007)

7
Euro Zone : the Euro area is the area comprising those [European Union] Member States in
which the euro has been adopted as the single
(OECD)

Exchange Rate Regime : the rules under which a country's exchange rate is determined,
especially the way the monetary or other government
authorities do or do not intervene in the exchange
market. (Deardroff, 2001)

Exchange Rate : the rate at which one national currency is exchanged for another (Sloman,
2006); the price of one currency stated in terms of
another currency (Rugman, 2006)

HICP : Harmonized Index of Consumer Prices, measure of prices for the purpose of assessing
price stability. (OECD)

Inflation : An increase in the general price level, e.g. in the consumer price index (ECB)

M3 : M3 equals to M2 + Repurchase agreements + Money market fund (MMF) shares/units

+ Debt securities up to 2 years (ECB)

Money Supply : the total amount of money held by the nonbank public at a point in time in an
economy (Johnson, 2005)

Nominal Exchange Rate : the price of one currency in terms of other which is
determined in the currency market (HM Treasury,
2003)

8
Open Market Operation : the sale (or purchases) by the authorities of government
securities in the open market in order to reduce (or
increase) money supply (Sloman and Hinde, 2007)

PPP (Purchasing Power Parity) : the rates of currency conversion that equalise the purchasing
power of different currencies by eliminating the
differences in price levels between countries (OECD,
2001)

Price Stability : “Alan Greenspan (1989) defined price stability as … expected changes in the
average price level are small enough and gradual
enough that they do not materially enter business and
household financial decisions” (King, 2002)

Real Exchange Rate : the price of foreign (currency) relative to domestic goods and service
(Copeland, 1989)

Trade Balance : The trade balance is the difference between exports and imports of goods and
services (OECD)

Unemployment : the number of people who are actively looking for work but are
currently without a job (Sloman and Hinde, 2007)

9
 EXECUTIVE SUMMARY

In the European Economic and Monetary Union (EMU), the single currency – the Euro – has
been relentlessly appreciating consecutively for five years during its seven years of existence.
The Euro reached its 27-year high at 1.4872 in November 2007 – rising over 23 percent since
December 2005. Along the Euro development course, EMU economic condition has recovered
from struggling with recession to its present vigorous economic state.

Nevertheless, exchange rate movements influence the performance of other macroeconomic

elements such as price, export-import, inflation, output, employment, and growth. These
elements have reciprocal relationships with exchange rate which means, changes in these
elements influence exchange rate movements in return.

Signs of economic slowdown have arisen in the course of Euro appreciation. The high external
value of the Euro is not reflected in the economic statistical data. Thus, the equilibrium value of
the Euro is open to discussion. Moreover, it is open to debate as to what extent the EMU
authorities will hold on to current policies whilst aiming to maintain the economic stability and
growth outlook. For that reason, the following need and scope exist:

1. to assess the performance of Euro appreciation

2. to identify impact of the Euro strengthening to the EMU economy.
3. to analyse the appropriate policies to adjust the imbalances.
4. to assess the cost and feasibility of such policies

Next, the challenges for EMU authorities lie in the policy making to adjust the impact. This
dissertation is an exploratory research to adequately explain the relationship of Euro
strengthening – against the US dollar – and EMU economy. The study is based on macro
economic approach on EMU economy. Literature reviews to identify the area of imbalances
were conducted. Statistical data from reliable sources were analysed to support arguments of the
Euro strengthening impacts with solid evidence. Three macroeconomic policy approaches are
being proposed as recommendations to adjust the imbalances. Next, hypotheses of transmission
mechanisms are presented to provide descriptive idea of how policy changes affect the

10
performance of economic elements and to communicate the argument on the cost and feasibility
of implementing such policies.

In conclusion, Euro appreciation has caused imbalances to the EMU economy. The right
macroeconomic policy is needed to adjust these imbalances. Thus, this dissertation is intended
to contribute recommendations to EMU authorities in assessing the best policy approach.

11
 1. RESEARCH AIMS

Since its inception in 1 January 1999, the Euro experienced two years of depreciation followed
by appreciation for the subsequent 5 years. Reaching over its 27-year high at 1.4872, it is
questionable that the performance of Euro reflects the current economic condition of EMU.
Beside the robust performance in the Euro Zone and the emerging of Asian countries,
apparently, the weakness of the dollar is perceived by the market as the most likely reason.
Despite, the sluggishness shown in the economic data, the ECB and government still hold their
current macroeconomic policy unchanged. Therefore, it is open to debate as to what extent the
EMU authorities will hold on to their current policies while aiming to maintain the economic
stability and growth outlook. For that reason, there exists a need to analyse the appropriate
policies for stabilising the imbalances.

This dissertation focuses on the following research aims:

 Assess the likely impacts of Euro strengthening on EMU economy
 Propose macroeconomic policies to anticipate the imbalances in the EMU economy from
Euro volatility.
 Evaluate cost and feasibility of implementing suggested policies.

1.1 Research Questions

1. How is the development of Euro against the dollar?

a. What are the major factors behind the Euro appreciation?
b. What are the systems used in determining exchange rates equilibrium level?
b. Is the Euro overvalued?

2. What are the effects of Euro strengthening for the EMU economy in terms of macroeconomic
objectives?
a. How does macroeconomic data (inflation, interest rate, money supply, trade balance,
Gross Domestic Product) signals the imbalances caused by Euro strengthening?
b. What are the macroeconomic issues as the result of Euro strengthening?

3. What are the policies to adjust macroeconomic issues caused by Euro strengthening?
a. What are the cost and feasibility of the suggested policies?
b. Which is the best possible policy?

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1.2 Significance of Research

“Real exchange rate appreciation can raise uncertainty about future values of exchange rate”
(Grier, 2005, p4). The knowledge of a nation currency determines the money related decision
making. The decision of the citizens in raising their money on investment and savings
determines the flow of the growth of GDP, aggregate demand, and prices, which consequently
affect the way authorities construct their economic policies.

For domestic EMU economy, decision makers are eager to see the continuation of Euro
development. This research tries to clarify the current EMU economy state in association with
Euro currency performance. What effect does a strong Euro have in regard to the EMU
economy? Which best macroeconomic policy should the ECB apply to adjust the imbalances?
This research intends to contribute knowledge to the decision makers in the field of business and
policy making.

1.3. Methodology

There are three methods utilized in this dissertation. First, literature reviews in the area of
exchange rate related to macroeconomic issues, the theories of exchange rate determination, and
the EMU macroeconomic policies. Second, detailed study on economic indicators data was
compiled to generate charts and statistical arguments. This economic data allows the author to
arise genuine analysis on the Euro exchange rate performance and its relativity to EMU. Third,
simulations of policies transmission mechanisms are constructed to assess the cost and feasibility
of such policies (see Chart.1).

1.4. Dissertation Framework

The framework of this research is organised into six parts. First part discusses the research aims
and explains the research aims, methodology, framework, and limitation. Second part introduces
the Euro and EMU economy by focusing on the main factors behind the Euro appreciation trend.
Third part explains macroeconomic factors to be considered in relation to the problem. Next, the
effects of Euro strengthening to EMU economy are analysed. The main contribution lies in the
following section which researches possible macroeconomic policies to anticipate/adjust the
imbalance caused by Euro strengthening by assessing of cost and feasibility of implementing
such policies. The recommendations to EMU authorities are integrated in this section. The final

13
section presents conclusions of overall recommendation to adjust macroeconomic imbalances
caused by Euro strengthening and the summary of overall findings.

1.5. Limitation

In compiling sources of literatures and statistical data, the author is challenged through various
limitations in the context of this dissertation. The main purpose is to stay in accordance with the
research aims and objectives. Thus, the following explains the limitation that has been set.

 data availability and sample population: in the early research, author desired to
research the development of Euro against the US dollar, UK pound sterling, and
Japanese yen. Most reviews and previous researches on macroeconomic issues and
policies are mostly focused on the development of the Euro against the US dollar. Thus,
this research concentrates on EMU (not EU) to characterise the countries that adopt the
Euro as single currency.
 time period for statistical data and literature reviews: to avoid ambiguity in referring to
statistics of economic data, data collected for this research is restricted to Euro Zone and
US economic indicators released between January 1999 and December 2007. But, not
limitation applied on the time period on literature reviews.
 category of proposed solution: due to the number of policies exist, macroeconomic
policies presented in this dissertation are limited to EMU main policies to adjust issues
presented in section 4.
 problem solving target : the policies presented here are not aiming only adjusting the
current Euro value, but also, it focuses on the macroeconomic issues that need to be
fixed, although in the suggestions may include approaches to adjust the pace and
direction of exchange rate.
 analysis presentation: the Euro exchange rate value are presented in terms of
EUR/USD, which means one Euro represent that amount of dollar. Analysis made are
based on fundamental analysis and technical analysis from statistical data. Thus, market
responds and institutional speeches are avoided.

In conducting this research, there are limitation faced by authors which resulting adjustment
to the contents. The credibility of data are varies due to the unpredictable market response.
Therefore the theory is not easily modeled because of the complication above and the issues
are overly extensive.

14
Chart 1 Detailed Methodology

THE IMPACT OF EURO STRENGTHENING TO THE EMU ECONOMY: A REVIEW

Identification of Research Aims

Hyphothesis 3
Literature Reviews Hyphothesis 2
Hyphothesis 1
Identification of euro
on the euro and EMU Economic data
effects limits the
economy, exchange Euro appreciation is explains the
possible policies to
rate theories, current caused by internal relationship of
adjust
macroeconomic issues and external factors exchange rate
macroeconomic
in the EMU, and of EMU and macroeconomic
issues caused by
macroeconomic policies issues
euro strengthening

Statistic and Data Analysis

Simulations of Policies Transmission Mechanisms

Summarise Analysis and Conclusion

Generate Further Research Question

Source: Author

15
 2. INTRODUCTION

The Euro has been appreciating by over 23 percent since the end of December 2005. It reached
its all-time low at $ 0.8252 in October 2000 (ECB) (see Chart 2). The trend seems to have
continued since the Euro is still seen hovering around its highest point $1.45 – $1.47 (write the
source of this bit of data) by the end of 2007.

Chart 2
Euro-dollar Development
December 2005 - January 2008

Currency fluctuation in the financial market is often caused by short-term movements to satisfy
the market expectation. It is when the market psychologically looks for further gains in the
currency, it becomes the fuel for the continued rise of the Euro; hence the cause of rise in the
Euro is regarded as a market sentiment. However, behind the market sentiment there has to exist
underlying fundamental reasons. Some major events have contributed to the prolonged
appreciation of the Euro. First is the improvement within the Europe, real interest rate

16
differential between EMU and US, the economy slowdown in US, and the emergence of Asian
countries.

2.1. Integration economy and monetary in Europe

De Grauwe (2005, p28) emphasized that integration in Europe would benefit an expansion of
trade by 20 to 40 percent. Countries within the Euro account for 16 percent of the world GDP
which is highly competitive compared to the 22 percent share of the US, and Euro countries
account for 19 percent of the world trade which is 4 percent higher than the US (Frisch, 2003).
The positive views of the EMU economy are enhanced by the following arguments: 1) Differing
productivity developments in the U.S. and in Europe (Corsetti and Pesenti, 2000); 2) Prosperous
economic view; and 3) Framing of market beliefs (De Grauwe, 2005).

The Single European Act in 1986 brought about the next stage of European economic
integration which was followed with the accession of the single currency Euro on January 1999
to realize the monetary union within Europe. The creation of the ECB and of the Eurosystem
according to R. Mundell (1998) transformed the power configuration of the international
monetary system. The intra Euro has benefited the economy in several aspects: (1) trade
expansion, (2) economies of scale, (3) productivity growth, (4) attracting FDI inflow, and many
others (Barrell and Choy, 2003, p19). The intra-Euro area trade has increased around five to ten
percent boosted by the single currency (Baldwin, 2005).

This integration and the benefits have given growth in competitiveness for Europe against
United States and other emerging Asian countries. According to CIA world fact book, EU
population reached almost half a billion people – 490,426,060 people in July 2007 – which is
only around seven percent of the world’s population – 6,602,224,175 people in July 2007–
competing with India and China.

The benefits gained by the EU from the integration has allowed the Euro to appreciate; positive
outcomes have built the economy stronger, encouraged market to build confidence on Euro
currency and concurrently, accelerate the appreciation of Euro currency.

2.2. Deterioration of US economy

The rise of Euro has been focused mostly on Euro dollar exchange rate while the Euro has also
made significant adavnces against the pound sterling and yen. Many arguments have tried to

17
relate the rise of Euro exchange rate to the deterioration of US economy, but not necessarily to
the robust UK economy or the sluggish Japanese economy. Clearly, market perspective
indicates that weak dollar plays the important role.

Since early 2006, there has been a slow down of US growth, whereas Euro Zone growth has
tended to accelerate. Bizimana (2008) pointed out that the imbalances which have accumulated
in the US economy: the property bubble, swelling household debt levels, the current account
deficit, etc., has resulted in lower growth outlook. The higher differential between the Euro
Zone and the US in area of growth, demand and capital flow, the higher the Euro will appreciate
(Corsetti, n.d.).

Ben Bernanke, President of the US Federal Reserve, admitted the country’s slow growth is partly
stimulated by the crisis in US housing bubble and the fall in labor market. The high inflation in
the US was stated due to exceptional increase in oil prices and food prices (Crutsinger, 2007).

2.3. Real Interest Rate Differentials

According to Harvey (2006), Uncovered Interest Rate Parity Theory (IRP) is described as
“interest-bearing assets through out the world must be identical once expected exchange rate
movements are taken into account” (p3). Copeland (1989) explains that uncovered IRP
disregards the differential between domestic and international interest rate (p86).

Asymmetric economic development between the EMU and the US has naturally led to different
monetary policy approaches. The EMU’s recovering economic condition since the end of 2005
allows the ECB to raise interest rate to a high point of 4 percent. In contrast, the US financial
crisis required expanding monetary action by rate cut to 4.25 percent (see Chart 3). A recent
study (Lien, 2008) indicated that the damage of the US financial condition is enhanced by
market prediction of Federal rate cuts that will continue for 50-100 basis points further during
2008.

Since mid 2002, long term interest rate differential between the Euro Zone and the US has been
negative - ranging from 0.25 to 2.5 percent. “Based on Uncovered IRP that the nominal interest
rate differential is equal to the expected decline in the exchange rate” (Arestis et al., 2001).
Byrne and Derbin (2003) confirmed that “except under conditions of massive intervention by
central banks, interest rate parity gives a pretty reliable explanation of the difference in nominal

18
interest rates and the spot and forward exchange rates”. Thus, this confirms the Euro
appreciation trend was signaled by the negative differential and expected changes in future
interest rate.

Chart 3
EMU vs. US Interest Rate
end of quarter value

1 ECB Fed

0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2005 2005 2005 2005 2006 2006 2006 2006 2007 2007 2007 2007
Source: ECB statistics, Federal Reserve Bank of New York

2.4. Emerging Asian Countries

After the financial crisis in 1998/1999, emerging Asian countries like China, India, and Korea
developed their exchange rate policy towards deeper regional cooperation. They have been
practicing tight competitiveness to raise their economy even further. They have departed from
poor countries to transform into countries that have developed at a rapid pace (Suttle and
Fernandez, 2005). For example, China improved its real GDP by 9.7 percent annually, which
catapulted its economic growth by over 11 times, and raised its world rank to 3 rd from 27th
(Elwell, 2007). Another country that attracts the world attention is India. India has real GDP
growth rate of average 7.8 percent annually, and by 2006, India’s economy in terms of PPP rose
to the fifth largest. These countries are increasingly important for EMU as major trading

19
partners; therefore, positive developments in emerging Asia has indirect contribution to EMU
(ECB, 2005, Schiff, 2006).

Chart 4
World Real GDP Growth
per cent, year over year
12
2005 2006 2007

10

0
Euro Zone US China India World
Note: World GDP data are calculated based on market exchange rate.
Source: The World Bank, US Bureau of Economic Analysis, IMF, ECB.

The four main reasons above lie as the primary background of EMU economic changes that have
caused the appreciation trend for the Euro. Exchange rate volatility contributes continuously to
cause changes in economy which are described in the economic indicators.

3. RELATIONSHIP OF EURO AND THE EMU ECONOMY

In order to comprehend the basic arguments of the Euro appreciation vs. stability for
macroeconomic issues related to exchange rates, it is useful to briefly understand the
macroeconomic elements related to four major macroeconomic objectives and their relationship
to exchange rate in general. These objectives are (i) full employment, (ii) price stability, (iii) a
high, but sustainable, rate of economic growth, and (iv) keeping the Balance of Payments in
equilibrium. Changes caused by Euro strengthening can be identified early by evaluating aspects
that determine the stability of aforementioned objectives. Changes in aspects such as inflation,
money supply, trade balance, and GDP provide a foundation for forecasting the EU economy

20
growth, and also indicate whether the current economic policies are resilient with the
fundamentals or the need exists to adjust such policies.
The aim of this section is to provide a basic understanding for the relationship of exchange rate
and significant economic elements. The discussion is strictly limited to the main elements that
signal the changes in EU macroeconomic objectives.

3.1. Inflation

Inflation negatively affects the currencies’ marginal ability to buy a set of goods and services.
Increase in inflation rate decreases the purchasing power of domestic currency, but when
combined with appreciation of exchange rate, this gives short-term indirect improvement of
domestic PPP through lessened import inflation. An example case is that a high Euro lowers the
import inflation of high oil price on EMU. "Price stability is defined as a year-on-year increase
in the Harmonised Index of Consumer Prices (HICP) for the Euro area of below 2 percent."
(ECB). Euro area’s HICP, which reflects Euro Zone price stability, showed inability to contain
below 2 percent inflation after May 2000. HICP climbed over 3 percent for the last 2 months of
2007. Those are the same periods when the Euro was seen to appreciate and also reached an all-
time high at the end of 2007 in the process. Another argument proposed is that the decision of
the ECB to not reduce interest rates has given more room for Euro and inflation to appreciate.
This shows that a strong Euro contributes to the inflationary pressures within the Euro Zone.

3.2. Interest rate

Interest rate rise acts as a booster when economy needs to increase output and promote growth.
In contrast, appreciation of exchange rate gives downward pressure to interest rate. Interest rate
and exchange rate has a linear link. A rise in interest rate affects the supply and demand of
exchange rate and causes appreciation in exchange rate. Euro zone interest rate has been
plummeting since the inception of Euro to 2 percent May 2003 and increasing to 4 percent by
mid 2007. For growth reasons, the ECB interest rate rise has not only helped EMU to recover its
economy strength, but has also caused the Euro to appreciate further. However, post June 2007,
the Euro appreciation could be linked to Federal Reserve rate cut, thus applying pressure upon
the ECB to lower interest rates.

3.3. Money Supply

According to Herberner (1999), the ECB conducts its monetary policy through a Keynesian
approach. In this approach, rise in money supply leads to fall in interest rate and exchange rate.

21
Euro Zone M3 money supply has grown in a rate above 10 percent which is above the ECB
expected rate of 4.5 percent (Neumann, 2003, p13). A larger money supply reduces the
purchasing power and exerts a depreciative pressure upon the Euro; however, this condition also
causes inflationary pressure which further causes interest rate rise.

3.4. Trade Balance

Trade balance refers to “the difference between the (Euro) value of goods and services sold
abroad and the (Euro) value of goods and services purchased abroad (Makin, 2000). Balance of
trade is only concerned with the performance of export and import of a nation. A nation
experiences a trade deficit when it has a higher demand to import than to export goods. The
increase in import will lower the demand for domestic currency, thus exchange rate will
depreciate (Porter, 1998, p5). On the other hand, exchange rate appreciation increases the
purchasing power of the currency and thus initiates higher import, but leads to a fall in demand
for exports. The Euro Zone’s export has been declining around 2 percent in the last few months
of 2007 due to the emergence of a strong Euro. The high value of Euro corresponded to the
increase in imports and has caused imbalances; a deficit of 2.1 billion Euro was posted on
December 2007 for the first time in more than a year. However, Makin’s (2000) study concluded
that there is little evidence of exchange rate level as the determinants of trade balance.

3.5. Gross Domestic Product

GDP represent the total output value of income and expenditure terms of prices actually paid
(Rugmann, 2006). GDP component include demand, output, consumption, investment, and
external balance (export and import). In the short-term, high exchange rate has positive
relationship with GDP, because consumption is buoyed by ‘cheaper’ price due to the
improvement of purchasing power. But in a longer term, strong currency causes prices to rise
and price stability upward risk. A strong Euro pushed the European Commission for cuts in its
forecasts for annual economic growth that is already loaded with high oil price, economic
deterioration in the US, and higher forecast in borrowing costs.

Is the Euro “overvalued”?

Economic indicators have shown that a higher Euro does not necessarily reflect a healthy
economic condition. The abovementioned conditions show that strong Euro causes disparity in
the components of inflation, monetary policy, balance of trade, and growth and thus, suggests the

22
Euro is overvalued. All of the arguments above point out the relationship of exchange rate and
Purchasing Power Parity (PPP). Arestis (2001) suggested two appropriate benchmarking in
order to have the correct value of the Euro which accurately corresponds to trade balance and
PPP.

In an open economy like EMU, the law of one price states that two identical goods must have the
same price when translated into a common currency. In his book, Copeland (1989a, p74)
suggests that based on the assumption of law of one price, PPP states the differences in inflation
rates between two countries will be offset by the changes in countries’ exchange rates. Catão
(2007) suggests the relation of real exchange rate and Purchasing Power Parity theory to
determine whether a currency is overvalued, consequently partly ignoring the nominal exchange
rate. For example, if 1 Euro equals to 1.4 dollar, the nominal of 1 dollar equals to 0.1234 Euro.
However, if it requires 1 Euro to buy Big Mac in United States, the real exchange rate shows that
it requires more than 1.4 dollar for a Big Mac in Europe (see Table 1).

The Big Mac index translates PPP in terms of McDonald’s product to show the degree of a
currency overvaluation or under valuation relative to the dollar (Economist.com). According to
the Big Mac Index, Euro is trading above its supposed ‘real’ level by 22 percent. In his study,
Bizimana (2008) concluded that by using the PPP approach, the Euro equilibrium range is 1.15
to 1.25 per dollar (see Chart 5). This overvaluation is due to factors such as “lack of response of
time” and “short-term capital inflow” (Porter, 1998, p5).

Based on the Big Mac index and PPP calculation of Bizmana, the condition of Euro above 1.25
per dollar causes imbalances in the economy and thus, requires adjustment to bring the current
level to the appropriate equilibrium.

In order to understand the reasons behind Euro appreciation and the nature of the imbalance that
might or have arisen caused by Euro, it is absolutely necessary to introduce the effects which
arise from appreciation.

23
Table 1 :
The Big Mac Index

Chart 5
Euro/dollar: nominal exchange rate and PPP

24
 4. THE EFFECTS OF EURO STRENGTHENING TO EMU ECONOMY
The preceding sections have dealt with presenting the grounds for Euro strengthening and
the macroeconomic elements that build strings necessary to identify imbalances. The Euro
area fundamentals do not necessarily reflect the state of its economy. Instability in areas of
export, price, and growth signal that the Euro strengthening has marked its impact. This
section is represented to show the channel of Euro strengthening effect transmitted to
macroeconomic factors.

A high value currency weakens the competitiveness of a nation’s goods in the international
market. Since demand increases when price level decreases, the high exchange rate distributes
higher price level, and potentially lowers the foreign demand. The impact of euro strengthening
to prices and inflation are explained in the following discussions.

4.1 Shift in Demand

In the last quarter of 2007, Euro area GDP growth decelerated to 2.2 percent compare to the 3.1
the same quarter previous year. These GDP figures represent changes in EMU output, demand
and trade balance. Euro area export growth decline to 0.6 percent (Quarter 4, 2007) from 3.3
percent (Quarter 4, 2006). The theory of supply and demand shows that demand declines as
price increases. Thus, strong Euro leads to lower output (See Chart 6).

Chart 6 represents aggregate demand and aggregate supply curves of EMU and US. The demand
curve indicates that demand declines as price increases. The supply curve indicates that supply
increases as price increases. A strong Euro leads to ‘expensive’ exports and ‘cheaper’ imports.
It causes EMU-made products to be less attractive than its major opponent the US. As a result,
consumers shift their demand to a lower “cheaper” currency – the dollar – thus causing the
demand of output curve in US to shift upward.

Export represents the total of foreign demand of EMU’s products. Since, the EMU’s exports
amount to over 20 percent of its GDP, this foreign demand has been in support of EMU growth.
Thus a decline in export directly affects EMU growth outlook.

25
 Chart 6 : Demand Shift in EMU and US
________________________________________________________________
__
US
Price EMU Price

Demand
Demand
Suppl y Supply

D D

Output Output

Source: De Grauwe, 2005

Supposed wage and labor mobility are constant, thus the adjustment for this imbalances is solely
on the price decrease, because supplier would produce more when cost is lower. To summarise,
a strong Euro delivers high prices which leads to lower demand and output in EMU.

Inflation Risk Rising

In the last quarter of 2007, Euro Zone HICP is seen to increase sharply from 1.7 percent to 3.1
percent, where concurrently the Euro appreciated by 12 percent (1.3359 – 1.4966).
Theoretically, demand shift causes prices and output shift in the same direction. But, recent
events of increasing world oil price and food price has created an inflationary pressure within the
Euro area. Only in 12 months of 2007 itself, the crude oil price increased from $49.90 per barrel
to $97.85 per barrel (Nymex). This is called import inflation – inflation caused by domestic
consumption of foreign goods.

Although strong euro causes higher price of EMU goods, theoretically, it creates deflationary
pressure on prices. Since EMU inflation has increase over ECB’s annual target, this offsets the
deflationary pressure on exchange rate. Therefore, ECB would prefer to maintain the value of
Euro at the current level otherwise lower Euro causes inflationary pressure.

26
 Chart 7: Euro Area Indices of Consumer Prices
Annual Rate of Change
%
4
HICP
ECB target
3.5

2.5

1.5

1
Jan- Apr- Jul- Oct- Jan- Apr- Jul- Oct- Jan- Apr- Jul- Oct-
05 05 05 05 06 06 06 06 07 07 07 07

Source: ECB statistics, Eurostat

The aforementioned contradiction challenge authorities to create a policy to contain both

exchange rate stability and inflation. Grier (2005) found strong evidence that real exchange rate
appreciation can be costly due to uncertainty about the future. In this case, uncertainty the future
value of exchange rate and the type of changes in future polices. Moreover, Grier’s hypotheses
on developing countries show that increased real exchange rate uncertainty significantly lowers
output growth and growth outlook. Consequently, authorities’ main concern would fall on the
policy to bring inflation lower and demand shift to equilibrium. Demand-side policies will be
discussed further in the next section.

27
 5. POLICIES TO ADJUST MACROECONOMIC ISSUES CAUSED BY EURO
STREGHTENING

Although the above imbalances which appear in the Euro Zone’s economy are not yet alarming,
Mishkin (1998, p24) agrees that authorities should not wait for apparent signals of imbalances
because it would be too late to handle imbalances prudently. Considering the possibility that the
deterioration of US economy may not hit its lowest point anytime soon, the Federal Reserve will
most likely start raising interest rate while at the same time the ECB will start lowering it. This
will give a boost to US economy, improvement in US current account, and stronger currency.
Even worse, the trend could be carried over to the following year. Thus, it is wise for the EMU
authorities to consider a way to arrest the march of the relentlessly appreciating Euro with a
suitable policy.

There are many macroeconomic policies that can be adapted to adjust economic imbalances;
however, this dissertation selectively focuses with only those that react directly with exchange
rate, namely: monetary policy, fiscal policy, exchange rate policy, and sterilised intervention.
These policies are meant not strictly to prevent euro from appreciating but also to focus on the
fluctuations of macroeconomic elements caused by euro strengthening. Each policy options will
be discussed related to its cost and feasibility in EMU condition.

Grier (2005) argued that without policy intervention, the real exchange rate appreciation “can
potentially create economy costs”. The category of macroeconomic policy in this section is
based on the following assumption. Exchange rate policy refers to the arrangement of exchange
rate management. Exchange rate policy is not exclusively presented because exchange rate
policy can be a monetary policy, fiscal policy or a mix of both. Exchange rate policy can also
refer to the exchange rate regime chosen by a country. The EMU is operating in an open
economy and is adopting a flexible exchange rate. Because it is considered unfeasible for the
EMU to change its exchange rate regime, thus, the analysis is not presented. Accordingly, the
following analysis and discussion limits the use of theory in the area of aforementioned
characteristics of the EMU economy.

28
5.1 Monetary Policy

5.1.1 Expansionary Monetary Policy

Monetary policy refers to the manipulation of money supply and interest rate to influence
aggregate demand, unemployment and prices to the desired direction (Friedman, 2004).
Monetary policy can be expansionary or contractionary. Both systems influence exchange rate
indirectly in opposite directions. Chart 8 shows how expansionary monetary policy lowers
money supply and increases interest rate which dampens the demand and value of exchange rate.
Moreover, there will be improvement in trade balance which promotes growth and prices.

Chart 8 : Expansionary Monetary Policy Mechanism

______________________________________________________________________

Investment ↑
Interest Rate ↓ D foreign asset ↑
Saving ↓

GDP ↑
Aggregate
Money Supply ↑ Demand ↓

D for foreign ↑ ↑
Exchange Rate ↓
Exports Prices
asset ↓ ↓
Imports

Source: Slomand and Hinde (2007, p647)

In order to adjust the imbalances caused by Euro strengthening, the ECB should react by
expanding M3 and no longer put interest rate on hold (Breuss, 2002, p11). In a flexible
exchange rate regime as in the EMU, the transmission mechanism in Chart 8 affects the expected
rate of return on Euro deposits. Consequently, demand for Euro will be lower and the short-run
effect would be the Euro depreciation. This will bring Euro zone balance of payment to
equilibrium. This is the transmission mechanism of expansionary monetary policy.

5.1.2 EMU monetary policy

EMU monetary policy is conducted by the ECB. The ECB plays a role as an independent body
from the government. The primary objective of the ECB which is mandated in the Maastricht

29
Treaty (1972) is price stability and other objectives to be pursued if not interfering with price
stability. However, in practice, the ECB has been criticised to only focus on price stability of
annual increase in HICP of less than 2 percent (ECB). Svensson (2000) argued that this
statement is ambiguous and asymmetric, while in practice, the Eurosystem targets on 1.5 percent
inflation with tolerance interval of plus/minus 1 percent. Moreover, Svensson (1998), Mishkin
and Schmidt (2001), and Breuss (2002) claimed that it is possible for the ECB to “not only
stabilise inflation” but also to “stabilise output”. A contrasting argument was given by Sibert
(n.d.) that given multiple objectives, central banks credibility is at risk because the higher
flexibility in either inflation targeting or exchange rate targeting, the lower the effectiveness of
future monetary policy.

5.1.3 Effectiveness of Monetary Policy

In his work “The Role of Monetary Policy” (1968), Friedman compared four types of targeting by
discussing their strength and weaknesses. These basic types are: 1) exchange-rate targeting; 2)
monetary targeting; 3) inflation targeting; and 4) monetary policy with an explicit goal, but not
an explicit nominal anchor. He recommended monetary targeting which was considered less risky
to achieve price stability. In a more recent study, Svensson (2008) and Friedman agreed on the
effectiveness of inflation targeting to maintain price stability based on the evidence provided in
21 countries.

Mishkin’s (1998) and Svenssons’ (2007) studies analysed this theory on the sample of countries
who conducts inflation targeting. The result confirmed that success stories showed inflation
targeting is an effective means of monetary policy.

5.1.4 The weaknesses of monetary policy

Classic weakness of monetary policy is that it cannot target both exchange rate stability and
stable inflation. By bringing down the high value of Euro, the ECB is adjusting the external
value of Euro; thus, it costs the EMU with imported inflation which leads to increase in domestic
inflation (Sibert, n.d). Conversely, as discussed in section 3, increasing interest rate is one of the
instruments to bring down inflation. Suppose for example, a strong Euro holds inflation.
However, to bring Euro to equilibrium, the ECB monetary policy includes lowering the interest
rate. Low interest rate leads to lower investment and output, which if accompanied with lower
Euro will raise inflation. This illustration leads us to conclusion that interest rate influence on

30
exchange rate is in conflict with providing low and stable inflation. So realistically, the ECB can
aim at only a single target.

Another limitation is that monetary policy effect on exchange rate only works short term; thus it
cannot (directly) influence output or employment (Bergo, 2002). However, over some time, the
price level will go up proportionately to the money supply (Rashid, n.d.,p7). De Grauwe (2005,
p34) noted that price has to decline to restore output to its initial level. If ceteris paribus, the cost
of implementing such a policy would amount to exchange rate overshooting. It is when Euro
continuously depreciated over time until it reached a lower value than before the money supply
increase (Cavallo, et al., 2002).

5.1.5 Recommendation to the ECB

Craig and Humpage (2001) clearly stated that “only when the disturbance that initiates the
central bank’s response is domestic in origin and monetary in nature, can monetary policy
achieve both price and exchange-rate stability”. Unfortunately, this is not the case for the Euro
strengthening. This condition points out the unfeasibility of expansionary monetary policy to
adjust the Euro. The contradiction is too costly for ECB to jeopardise the current stable
inflation. The logic is that by lowering interest rate, the ECB would successfully depreciate
Euro; however, this policy only influences exchange rate temporary while interest rate has been
adjusted for some medium-term, thus the future disturbances to price stability are more
significant.

5.2. Discretionary Fiscal Policy

5.2.1. Contractionary Fiscal Policy

Discretionary fiscal policy refers to control of fiscal budget through spending and taxation policy
to affect aggregate demand (Sloman & Hinde, 2007, p683). The method includes expanding or
contracting the fiscal budget so that factors of aggregate demand are increased or decreased to
maintain equilibrium. Aggregrate demand (AD) is composed by the total spending on
consumption, investment, government spending, and export minus import. Thus, when high
exchange rate negatively affects aggregate demand, price stability, and GDP, a decrease in
government spending will directly affect the aggregate demand. Chart 9 represents the
mechanism of contractionary fiscal policy (the opposite method is expansionary fiscal policy) to
contain exchange rate appreciation.

31
 Chart 9 : Contractionary Fiscal Policy Mechanism
____________________________________________________________________

Source: Author

The above chart shows two transmission channel of how fiscal policy affects exchange rate.
Firstly, fiscal is contracted by lowering government spending. This leads less borrowing in
international market needed to finance budget deficit which leads to lower interest rate. Such
interest rate differential would increase the demand for foreign assets and lower the demand for
Euro exchange rate, thus depreciate the exchange rate. The second channel is through the
dampening of goods market by taxation. Increase in taxation will reduce income and
consumption and drive down investment. Demand is deteriorated, but in the short-run, fiscal
policy does not affect output. Therefore, aggregate demand would fall and exchange rate would
depreciate.

5.2.2 EMU Fiscal Policy

EMU fiscal objectives are stated in the Maastricht Treaty in 1992 and in the Pact of Stability and
Growth. The fiscal disciplines is to maintain budget deficit less than 3% of GDP and public debt
less than 60% of GDP (De Grauwe, 2005). For the past 2 years, Euro area budget deficit has
been improving from 70.19 percent to 66.4 percent. Fiscal improvement is due to the positive
impact of Euro appreciation that lifts the economy state of some EMU countries.

32
5.2.3 Effectiveness of Fiscal Policy

Auerbach’s latest work (2005) suggested that fiscal policy has effective direct effect on
consumption, investment, and government spending and indirect effect on output. However, he
concluded that the success rate of implementing fiscal policy remains a question mark.

5.2.4 Weaknesses of Fiscal Policy

De Grauwe (2005, p29) stated that “by changing taxes and spending, the authorities… can create
large assymetrics shocks”. He argued that this is because taxation and spending in EMU
countries sum up to 50 percent of GDP. Therefore, the sensitivity to the EMU’s GDP could
directly cause lower growth.

The weak point of this mechanism is the causal of capital outflow. The EMU preferably
encourages capital inflow which in turns will promote growth. However, such capital outflow is
necessary in this policy to depreciate the exchange rate and shift demand into domestic
production. This would increase deflationary pressure on price and improve balance of trade.
Thus, effect of fiscal contraction is entirely dependant on exchange rate and inflation. If this
policy is adopted, the EMU will have to let capital outflow to stabilise the high Euro and contain
inflation.

5.2.5. Recommendation to EMU

Even though the transmission mechanism presented above focuses mainly on exchange rate and
price stability, perfect capital mobility allows complete capital outflow and so fiscal contraction
is ineffective (Hemming, 2002, p6). Unless the EMU prefers exchange rate stability more than
capital outflow, then, this policy is not suitable. Bruneau and de Bandt (1999), Aaerle et al.
(2001), and Perotti (2002) estimate that fiscal shocks in EU area and other advanced countries
have only “short-run response” or “statistically insignificant” (Hemming, 2002, p22).

33
5.3. Sterilised Intervention Policy

5.3.1 Sterilised Intervention Policy

Foreign exchange intervention is the practice of monetary authorities buying and selling
currency in the foreign exchange market to influence exchange rates (Neely, 2005, p3). Buying
(selling) actions directly decreases (increases) the total amount of home currency in the market,
which affects domestic money supply.

Below is an illustration of the ECB intervention for Euro appreciation based on classification of
effective intervention:

1) Leaning against the wind (breaking/reversing the trend; WIND): the ECB
intervention aims to reverse the Euro appreciation trend to depreciation trend.
2) Smoothing exchange rate movements (dampening or slowing the trend;
SMOOTH): the ECB intervention aims to reduce the pace of Euro appreciation.
The appreciation trend is still favorable for the ECB.
3) Leaning with the wind (WITH): the ECB purchases Euro to cause more
appreciation after the intervention episode than before the intervention episode.

However, it is noted that most central banks intervene for the purpose of first and second
classification, thus Égert, & Komárek (2006, pp 8-9) suggested to drop the third classification
because it simply indicates unsuccessful official intervention. As a side effect of foreign
exchange interventions, it seems that on average, interventions combined with interest rate
changes tend to increase exchange rate volatility from 30 up to 60 days after the interventions
took place.

To distinguish intervention from ordinary domestic Open Market Operation, most central banks
“sterilize” their operation by buying and selling domestic bonds to reverse the money supply
effect (Edison, 1993, p16). Hutchinson (2002) shared the same opinion for the operation
effectiveness, intervention should be “sterilized” from accommodating or reinforcing monetary
base, interest rate, or other policy measures. It is now an independent instrument of stabilisation
policy to target directly on exchange rate.

34
5.3.2 EMU sterilised intervention policy

In the year 2000, the ECB conducted several sterilised interventions to reserve the euro
depreciation. ECB utilised the signaling approach of future central bank’s monetary policy.
Frenkel et al. (2006) entailed that the ECB approach in conducting this policy is by signaling
their future action in monetary policy.

In this research, no mandatory requirements were found on sterilised intervention such as in the
previous policies. Thus, it is assumed that the ECB influenced exchange rate market until the
point of the ‘signaling approach’ is considered effective. This theory is based on assumption that
the market may take current action by predicting the future.

5.3.3 Effectiveness of sterilised intervention policy

A large volume of literature has focused on the study of rate of success and effectiveness of
sterilised intervention. Siklos and Weymark found that sterilised intervention operation has been
more effective in emerging markets because of more volatile exchange market (2007, p3) and
the success rates are higher if sterilised intervention policy objective is aligned with domestic
monetary policy (2003, p26). In countries like the EMU, where inflation targeting is the primary
objective of monetary policy, there is a risk of sterilised intervention conflict with inflation
objectives. Although the sterilised intervention, theoretically, offsets the effect of monetary
instrument, there lies the risk of limited success creating rising exchange market pressure. Thus,
to reduce significant unexpected effects of sterilised intervention, Sarno and Taylor (2001, p850)
emphasized that intervention policies should be in line with the underlying stance of monetary
and fiscal policy, because if central banks prefers to correct intervention with another
intervention, then the cumulative effect of intervention is nil (Fatum and Pedersen, 2007, p5).

5.3.3 Limitation of sterilised intervention policy

In contrary to the positive views of this policy, there are studies by Craig and Humpage (2001,
p5) that point out ineffectiveness of this policy to reverse the direction of an exchange rate
movement and instead it had a tendency only to ‘smooth’ the pace of appreciation or
depreciation. When the ECB “maintains an unchanged interbank rate … it automatically offsets
(or sterilizes) the impact of any exchange-market intervention on its monetary base” (Craig &
Humpage, 2001).

35
Schmidt and Wollmershäuser (2004, p21) pointed out that central banks could use this policy to
influence exchange rate movements. But even the most-utilised technique – the smoothing;
evidence of occurence in Japan is that the results were insignificant.

5.3.4 Recommendation to EMU

Previous studies have stronger arguments on the ineffectiveness of sterilised intervention policy
than on its effectiveness. Previous studies investigating the ineffectiveness based on actual
intervention policies of developed countries like Japan, US, and the EMU. The result is an
agreement of the futility of this policy. Conversely, previous studies assessed the effectiveness
of this policy by using different theoretical methods of calculation. Thus, the arguments for this
policy effectiveness are mostly empirical analysis to proposed advice for further progress.
Edison (1993) surveyed various literature after 1982 and concluded that empirical evidence
could not confirm effectiveness of this policy.

Sterilised intervention policy is not recommended for EMU to expect medium-term or long-term
result on the Euro development. But if the EMU considers that the trend of the Euro is
favourable and only targets to slow the current Euro rate, smoothing technique of sterilised
intervention policy should be effective. But it is to be borne in mind, that this policy is only
meant for short-term adjustment.

5.4. Recommendation to EMU

Each of three recommendations given above has its strengths and weaknesses. As a result,
deciding on which best policy to adopt is not easy because each policy does not offer ideal result
for EMU in adjusting imbalances. In 1960, Mundell-Flemming proposed a theory of Impossible
Trinity (Pandey, n.d.). This theory stated that it is unfeasible for economy to achieve three
following objectives at the same time:
1. Stability in exchange rate
2. Free capital movement
3. independent monetary policy

Consequently, the EMU with an open current account also encounters this conflict. It can aim to
stabilise the Euro and have capital flow move freely, but in the cost of forsaking interest rate as

36
instrument to fight inflation. This conflict remains unavoidable when ECB tries to keep
exchange rate and price stability intact.

Expansionary monetary policy is not favorable with the current EMU state. Although inflation
limit mandated in the Maastricht Treaty is below 2 percent, as discussed in section 5.1.2., ECB
allows tolerance level of +/- 1 percent. Inflation level up to the end of 2007 is still in the
tolerable band. For that reason, it is careless for EMU to jeopardise price stability by lowering
interest rate as stabilizing policy. But if the current inflation has reached over 3 percent, it is also
not proper to increase interest rate to defer inflation pace because this will raise the Euro even
higher. Accordingly, this policy’s conflict with price stability is inevitable for the Euro at this
level.

Contractionary fiscal policy is not eminent in this research. Factors influenced by this policy are
those that EMU prefer to maintain stability. The transmission of this policy is not feasible
without interrupting current monetary policy and thus jeopardising price stability. In regard to
its “short-run” effect, the implementation of fiscal policy proposed higher risk rate than
successful rate.

Svennson (2000) stated that the time required for policy to take effect since the implementation
period can be an economic cost if no consideration is given to policy making. For instance, if
monetary policy to affect inflation is implemented in 2007, it is foreseeable that this policy
causes effect to certain elements immediately, but not to inflation. EMU can expect to see
improvement in price stability at end of 2009. This limits the assessment of policy effectiveness
on adjusting the economy. Svensson (2000) concluded that his study shows that “monetary
policy requires one year taking effect on output and two years on inflation”.

For the above reasons, sterilised intervention policy is perceived to be direct and less
complicated to adjust the Euro and imbalances caused by it. Adopting this policy causes less
probability for new imbalance to arise, thus less future disturbance to other economic elements.
So, imbalances caused by Euro strengthening are expected to restore its equilibrium level by
adjusting the main cause – the Euro.

37
6. CONCLUSION

This research has tried to investigate the impact of Euro strengthening to the EMU economy.
The result is that EMU authorities can influence the development of Euro by means of
macroeconomic policies, namely: monetary policy, fiscal policy, and sterilised intervention
policy. The feasibility of each policy depends on other economic determinants such as inflation
level, budget deficit performance, and demand. Descriptive transmission mechanisms of such
policies also suggest the cost and feasibility of these policies.

Aside from all the theories presented and the attempts to explain the relationship of Euro
strengthening and macroeconomic policies, these mechanisms presented works perfectly if
ceteris paribus. Unfortunately, this is not a perfect world. The fact that the EMU and the Euro
operates in open economy complicates not only the making of but also the coordination of the
policy making itself. No one particular option of policies can solve the problem of Euro
strengthening without causing expected changes {and unexpected changes} in all other
economic aspects. If this is the case, then policy making issue requires continuous assessment
and flexibility.

In respect to current EMU policy, sterilised intervention policy is perceived most suitable to
adjust current Euro condition. However, the arguments lying here are too simple. Market
response and authorities forecasting approach are natural intervention in itself. Thus, the
exploratory study to present the most effective policy to adjust Euro strengthening and its impact
to EMU economy is inconclusive.

For further study, one can consider to present a large sample of other nations similar experience
and compare the result of their solution implementation. Next, it is possible to initiate testing
whether the samples’ solutions works on EMU. Finally, the transmission mechanisms of policies
presented in this dissertation are too ingenuous to not include the real complication in the EMU
economy. This dissertation rests these additional rooms for future work.

38
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