Exchange Rate Policies for the Transition to Emu

In this paper we formalize the framework for monetary and exchange rate policy presented in Bofinger and Wollmershäuser [2001a]. We develop a simple comparative static model for an open economy that allows us to discuss monetary policy under the exchange rate strategies of independently floating exchange rates, managed floating and absolutely fixed exchange rates. In contrast to the actual mainstream view of academics which emphasizes the so-called "two corner solution" with either absolutely fixed or independently floating exchange rates we favour as an intermediate solution the strategy of managed floating where central banks simultaneously control the interest rate and the exchange rate in a way that guarantees both, the achievement of domestic macroeconomic objectives and an equilibrium on the international financial markets. As an institutional framework for managed floating we examine the appropriateness of the Exchange Rate Mechanism of the current European Monetary System and we propose the necessary reforms