What does it mean that Denmark pursues a fixed exchange rate policy?
Denmark pursues a fixed exchange rate policy against the euro. This means that the value of the Danish krone against the euro must be kept stable against the euro. Danmarks Nationalbank achieves this by way of monetary policy.
What is the relationship between the fixed exchange rate policy and the monetary policy, and who is responsible?
A fixed exchange rate policy is just one of several possible strategies available to a country in the shaping of its foreign exchange policy. At one end of the spectrum is a regime of floating exchange rates under which the country does not seek to influence the exchange rate. The price of the currency is determined freely by the markets. This policy is practised, for instance, by the USA and Sweden. At the other end of the spectrum are countries that abandon their own currencies to use the currencies of other countries as their means of payment. This provides for a completely fixed exchange rate. This policy is practised, for instance, by Kosovo and Ecuador.
Monetary policy is the economic policy for which the central bank is responsible. The central bank basically sets a rate of interest that is passed through to the general level of interest rates in society. The exchange rate policy pursued by a country provides the framework for its monetary policy. When a country decides to pursue a fixed exchange rate policy, interest rates are reserved for managing the exchange rate, so they cannot also be used for controlling economic activity.
In Denmark, the government, in consultation with Danmarks Nationalbank, determines the foreign exchange policy to be conducted. Danmarks Nationalbank conducts monetary policy within the framework of the fixed exchange rate policy. In other words, the sole purpose of Denmark’s monetary policy is to keep the krone stable against the euro. Danmarks Nationalbank is free to conduct the monetary policy as it sees fit, and neither the Danish Parliament (Folketinget) nor the government can decide the monetary policy. The result is a clear division of responsibility for the economic policy. The government ensures that fiscal policy and all other economic policies support a stable economy. A stability-oriented fiscal policy is also essential for maintaining the fixed exchange rate policy.
Why does Denmark pursue a fixed exchange rate policy?
Denmark pursues a fixed exchange rate policy to ensure low and stable prices. As the euro area’s inflation target is 2 per cent over the medium term, the fixed exchange rate policy creates a framework for low inflation in Denmark.
Since when has Denmark pursued a fixed exchange rate policy?
Denmark has been conducting a fixed exchange rate policy since 1982 – initially against the German D-mark and then against the euro. The decision to pursue a fixed exchange rate policy without adjusting the exchange rate for economic policy purposes was made following a period of high unemployment and inflation and major imbalances in the Danish economy. Despite turbulence surrounding the Swedish krona in 1982 and the foreign exchange crises of the early 1990s, adjustment of the exchange rate of the krone has not been used actively in Danish economic policy, and the krone’s central rate against the D-mark and then against the euro has been unchanged since January 1987.
What is ERM II?
The European Exchange Rate Mechanism (ERM II) is the formal framework for the Danish fixed exchange rate policy. The euro is at the core of ERM II, and countries participating in the programme have central rates against the euro, but not against each other’s currencies. The value of the currencies may fluctuate within a band of +/- 15 per cent against the central rate. As part of the convergence criteria, countries wishing to join the euro must participate in ERM II and observe the fluctuation band for at least two years. Denmark does not participate with a view to joining the euro, but only because ERM II provides a framework for its fixed exchange rate policy. The European Central Bank (ECB) and the individual member state have an obligation to ensure that the currency observes the fluctuation bands.
What is the central rate of Danish kroner?
Denmark participates in ERM II at a central rate of 746.038 kroner per 100 euro. Because of the high degree of convergence, Denmark has concluded an agreement with the ECB on a narrower ERM II fluctuation band of +/- 2.25 per cent.This means that the krone can only fluctuate between 762.824 kroner per 100 euro and 729.252 kroner per 100 euro. Since the late 1990s, Danmarks Nationalbank has, in practice, stabilised the krone at a level much closer to the central rate. The krone is floating against all other currencies but the euro. There are no upper or lower limits on how much the exchange rate (price) of, say, the Swedish krona or the US dollar can move.
How does Danmarks Nationalbank manage the exchange rate of the krone in practice?
The exchange rate of the krone against the euro is determined by the supply of and demand for kroner relative to euros. Danmarks Nationalbank is responsible for ensuring that the exchange rate of the krone does not reach the upper or lower limits in the fluctuation band, but preferably stays close to the central rate. Danmarks Nationalbank generally uses two instruments to keep the krone stable against the euro: intervention and interest rate adjustment.
Intervention
If the exchange rate of the krone moves away from the central rate, Danmarks Nationalbank can intervene – i.e. buy and sell kroner against euro. Danmarks Nationalbank will buy kroner and sell euros if the exchange rate of the krone is moving away from the central rate in a depreciating direction – and conversely sell kroner and buy euros if the krone rate is moving away from the central rate in an appreciating direction.
Interest rate adjustment
Danmarks Nationalbank may also adjust interest rates to stabilise the krone towards the central rate. Danmarks Nationalbank will raise interest rates if the exchange rate of the krone is moving away from the central rate in a depreciating direction – and conversely lower interest rates if the krone rate is moving away from the central rate in an appreciating direction.