Typically, Germany has followed a more rigorous and generally 'tighter' monetary policy than the UK, probably because Germany experienced (under the inter-war Weimar Republic) a ferocious inflationary period stemming from an unregulated banking sector where many local banks were given the licence to print their own money. This experience is ingrained in the German psyche, and makes them determined to ensure that it never happens again - hence the political independence of the Bundesbank (Germany's Central Bank), which has long been charged with preserving the value of the D-Mark by control of the money supply and interest rates.
Under these conditions, domestic economic growth is associated with rising interest rates, as the controlled money supply is squeezed by increasing transactions demand for cash and liquidity, forcing the speculative demand to be satisfied with a reduced supply of money - driving up interest rates.
Increasing domestic interest rates encourage capital inflows and discourage capital outflows, thus shifting the demand and supply curves in the (D-M) Forex market in the opposite directions to the UK (relaxed monetary policy) case:
Thus, Germany typically experienced BoP surpluses rather than deficits, and the D-M tended to appreciate rather than depreciate over the post war period.
Internal Domestic Pressures arising from an appreciating currency, or a BoP surplus, are rather different from those facing a country with a depreciating currency or a BoP deficit - appreciation tends to reduce the comptetiveness of domestic production - possibly prompting greater efforts to efficiency improvement, while BoP surpluses simply allow for the accumulation of Forex reserves in exchange for sales of domestic currency - which puts further pressure on the Central Bank to limit domestic money supplies and keep interest rates high.
Pressures for re-valuation under fixed exchange rate regimes frequently lead to pressures for devaluation of competing currencies - the Franc, Lira and Sterling, since one country's BoP surplus MUST be offset by other countries deficits - for the world as a whole, there are NO Imports and Exports, and NO interplanetary Capital transactions - hence at the global level Forex balances must balance.
So, How Come German interest rates tend to be below those of the UK? There are two major reasons, on the basis of this analysis.
German inflation rates have typically been lower than those in the UK - so nominal interest rates will also tend to be lower in Germany than in the UK, since nominal interest rates can be expected to be the real interest rate plus the expected inflation rate - otherwise sensible people will not be prepared to save and lend money.
The German style of economic management leads to a more stable economic performance, and to an appreciation rather than depreciation of the currency - leading to a preference for D-M (other things being equal) compared with other international currencies. So German interest rates do not 'need' to be as high as UK rates to attract foreign capital and persuade domestic capital to stay with the D-Mark. However, the unification of Germany in 1989 led to substantial problems for the German governement, especially for its Fiscal balance, as the eastern lander became eligible for the west German rates of social security and the two currencies (East and West DM) were exchanged at 1 for 1. Since 1989, the strength of the German economy has suffered as a consequence, and the D-Mark has weakened somewhat.
Notice the effects of Inflation on the Exchange Rate:
Domestic Inflation at higher rates than international competitors leads to domestic cost increases and loss of international competitiveness - and a depreciation of the currency as a result. - the "British" experience.
Foreign Inflation at higher rates than domestic inflation improves the competitiveness of the domestic economy, leading to appreciation of the currency. - the "German" experience.
Germany, with a background of Monetary Prudence, was better placed and more likely to follow appropriate monetary policy when the world moved from Fixed Exchange rates to Floating Rates in 1971 (the collapse of the Bretton Woods (1947) agreement on fixed exchange rates)
The UK, on the other hand, had not been convinced of the importance of monetary policy (one Governer of the Bank of England in the 1950s/60s is reputed to have said that "money doesn't matter"). As a consequence, UK monetary policy was far too loose or relaxed in the early 1970s, under a Tory administration, and following the floating of exchange rates, which generated a considerable inflationary period and de-stabilised the economy. Hence, policies which had previously tended to lead to chronic BoP Deficits (associated with two major devaluations of sterling during the post war period) now led to inflation, as can be clearly seen from the Forex market analysis (see above
Under these conditions, domestic economic growth is associated with rising interest rates, as the controlled money supply is squeezed by increasing transactions demand for cash and liquidity, forcing the speculative demand to be satisfied with a reduced supply of money - driving up interest rates.
Increasing domestic interest rates encourage capital inflows and discourage capital outflows, thus shifting the demand and supply curves in the (D-M) Forex market in the opposite directions to the UK (relaxed monetary policy) case:
Thus, Germany typically experienced BoP surpluses rather than deficits, and the D-M tended to appreciate rather than depreciate over the post war period.
Internal Domestic Pressures arising from an appreciating currency, or a BoP surplus, are rather different from those facing a country with a depreciating currency or a BoP deficit - appreciation tends to reduce the comptetiveness of domestic production - possibly prompting greater efforts to efficiency improvement, while BoP surpluses simply allow for the accumulation of Forex reserves in exchange for sales of domestic currency - which puts further pressure on the Central Bank to limit domestic money supplies and keep interest rates high.
Pressures for re-valuation under fixed exchange rate regimes frequently lead to pressures for devaluation of competing currencies - the Franc, Lira and Sterling, since one country's BoP surplus MUST be offset by other countries deficits - for the world as a whole, there are NO Imports and Exports, and NO interplanetary Capital transactions - hence at the global level Forex balances must balance.
So, How Come German interest rates tend to be below those of the UK? There are two major reasons, on the basis of this analysis.
German inflation rates have typically been lower than those in the UK - so nominal interest rates will also tend to be lower in Germany than in the UK, since nominal interest rates can be expected to be the real interest rate plus the expected inflation rate - otherwise sensible people will not be prepared to save and lend money.
The German style of economic management leads to a more stable economic performance, and to an appreciation rather than depreciation of the currency - leading to a preference for D-M (other things being equal) compared with other international currencies. So German interest rates do not 'need' to be as high as UK rates to attract foreign capital and persuade domestic capital to stay with the D-Mark. However, the unification of Germany in 1989 led to substantial problems for the German governement, especially for its Fiscal balance, as the eastern lander became eligible for the west German rates of social security and the two currencies (East and West DM) were exchanged at 1 for 1. Since 1989, the strength of the German economy has suffered as a consequence, and the D-Mark has weakened somewhat.
Notice the effects of Inflation on the Exchange Rate:
Domestic Inflation at higher rates than international competitors leads to domestic cost increases and loss of international competitiveness - and a depreciation of the currency as a result. - the "British" experience.
Foreign Inflation at higher rates than domestic inflation improves the competitiveness of the domestic economy, leading to appreciation of the currency. - the "German" experience.
Germany, with a background of Monetary Prudence, was better placed and more likely to follow appropriate monetary policy when the world moved from Fixed Exchange rates to Floating Rates in 1971 (the collapse of the Bretton Woods (1947) agreement on fixed exchange rates)
The UK, on the other hand, had not been convinced of the importance of monetary policy (one Governer of the Bank of England in the 1950s/60s is reputed to have said that "money doesn't matter"). As a consequence, UK monetary policy was far too loose or relaxed in the early 1970s, under a Tory administration, and following the floating of exchange rates, which generated a considerable inflationary period and de-stabilised the economy. Hence, policies which had previously tended to lead to chronic BoP Deficits (associated with two major devaluations of sterling during the post war period) now led to inflation, as can be clearly seen from the Forex market analysis (see above
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