Introduction

Given the EC decision to liberalise capital movements by 1990, it is important to analyse the effects of this removal of capital controls on the inter-EMS exchange rates. This issue is important because, according to a popular point of view, disturbances external to the EMS (such as movements of the dollar driven by US monetary and fiscal policies) have led in the past to inter-EMS exchange rate tensions. This point of view is supported by the empirical observation that, in periods of strength (weakness) of the dollar, the Deutsche mark appears to be weak (strong) relative to the other EMS currencies.

One possible explanation of this empirical fact is based on the assumption that assets denominated in different currencies are imperfect substitutes in the portfolios of international investors. In particular, it is argued that the degree of asset substitutability between dollar and Deutsche mark-denominated assets is greater than the one between the dollar and other European currencies-denominated assets (such as the French franc or the Italian lira). In the presence of this type of imperfect asset substitutability, portfolio shifts (driven by changes in expectations and/or changes in fundamentals) will have asymmetric effects on the exchange rates between the Deutsche mark and the EMS currencies. For example, shocks that lead to an increase (decrease) in the demand for dollar assets will reduce (increase) the demand for the Deutsche mark more than the demand for French francs or Italian lire.