Economic conditions continue to improve, with growth at a satisfactory rate and inflation subdued, whether one considers the UK in particular or the world economy in aggregate. This cheerful prospect may be threatened however by financial developments, with some turbulence in foreign exchange markets and uncertainty about the future of monetary policy. In the UK this uncertainty is particularly acute following the surprise decision not to raise short-term interest rates in May.

In addition to our coverage of the United States as part of the world economy programme, four recent or current projects at the Institute involve comparisons between Britain and America. The main focus is on labour market institutions, productivity, training and education. This note draws on this work, and also on a recent visit to Washington to meet both policy makers and independent economists. It has benefited from discussion with the editorial board, but consists nevertheless of my own personal reflections.

The sterling exchange rate was unusually stable in the two years following its departure from the ERM in September 1992. In effective terms it fluctuated within a fairly narrow range around an average of about 89 on the new effective exchange rate index and this was approximately the level at which it ended 1994. Since then it has depreciated by over 5 per cent and at the time of writing (11 May) there is some uncertainty as to whether it will fall further. This largely unexpected depreciation is of sufficient size to influence the development of the UK economy and in particular to increase the amount of inflationary pressure at a time when there are doubts about whether monetary policy has been tightened enough to deal with that which already exists.

The pattern of real exchange rates has changed significantly since February. Our currency forecasts at that time were in line with the implied forward rates in financial markets, with the yen projected to appreciate slowly against the dollar, rising from 100 to the dollar in the first quarter of 1995 to around 90 to the dollar in 1997. Within Europe, we projected a further small appreciation of the D-mark and a continuing depreciation of the lira and the peseta. Overall, we expected ‘real exchange rates to stay approximately stable’. In the event, the yen rose strongly in March and April to around 80 to the dollar, while the D-mark rose from around 1.50 to 1.38 to the dollar. At the same time, the lira/D-mark exchange rate fell by over 10 per cent and the Exchange Rate Mechanism was placed under renewed strain, with both the peseta and the escudo being devalued. As a result, the Japanese and US real effective exchange rates are respectively 15 per cent higher and 7 per cent lower than we had previously expected. These developments also had a wider impact on financial markets. The discount rate was cut in Japan and Germany and long-term rates rose in Italy and Spain. Equity prices fell sharply in those countries with appreciating currencies and jumped up in most of the countries whose exchange rate has depreciated.

Official price indexes may overstate (or understate) inflation for a number of reasons. These include substitution bias, outlet bias, failure to allow properly for quality change, and failure to allow for new goods. This note finds that substitution and outlet bias are probably not significant sources of error in the UK. The other two sources most probably do lead to significant overstatement, but the size of the upward bias cannot at the moment be quantified.

‘Since, with technological advance, the quality of products tends to improve, the estimates of consumers' expenditure tend to understate the true growth in standards of consumption’. (CSO a 985, p. 72).

‘The Producer Price Indices … make some allowance for changes in models and specifications when these can be identified in terms of changes of cost or in technical performance…. [Allowances for quality change] are necessarily somewhat rough and seldom fully satisfactory’. (CSO 1985, p. 40, emphasis added).

It is now looking increasingly plausible that, at some point between the middle of 1997 and the beginning of 1999, a number of EC Member States (perhaps even a majority) will move to the final stage of Economic and Monetary Union. The macro economic consequences of EMU and the costs and benefits ofparticipating are already the subject ofactive and extensive academic analysis. Very little attention has so far been given to the question of how a two-tier EMU, with only some EC countries prticipating in Stage 3, would function and what implications there might be for those remaining in Stage 2.

The purpose of this Note is to highlight some of these issues, which will need to be studied and understood in much greater depth before a decision is taken. It looks at the legal and institutional framework set out in the Maastricht Treaty, the relevant experience of nearly-fixed European exchange rates from 1987 to 1992 and the economic and political implications of particular country configurations in a two-tier EMU, concluding that mutually satisfactory management of such a relationhip will require greater political will and co-operative spirit than has been in evidence so far.