Exchange Rate Shifts and Economic Developments in Western Europe

Real GDP in the industrialized countries is projected to expand by 2¾ percent in both 1995 and 1996. Recovery in Europe is set to continue at a healthy pace without gaining further momentum. Overall output growth is unlikely to be strong enough as to make substantial inroads into the generally high level of unemployment. High interest rates and fiscal retrenchment dampen activity in the countries with weaker currencies; in the strong-currency area, the recent exchange rate shifts constitute a severe test for these countries' external competitiveness. The international business cycle recovery, which became firmly established in 1994, continues. GDP growth in 1995 is projected at 3 percent for both the U.S. and OECD Europe. The U.S. economy has entered a period of slowing activity, caused by endogenous cyclical factors as well as monetary restriction, and the further course of the cycle is not quite clear. The persistent weakness of the dollar vis-à-vis the DM and the yen has been accompanied by exchange rate turbulence within Europe. The block of hard currencies which has emerged since 1992, has appreciated by some 10 percent in real-effective terms against the weaker currencies. Nevertheless, the rate of economic growth is virtually identical for both groups of countries. It is true that the sizeable devaluations have largely contributed towards pulling the weak-currency countries out of the 1992-93 recession and that growth continues to be export-driven to a higher degree than in the hard-currency area. However, domestic demand is considerably dampened by high interest rates and the restrictive stance of fiscal policy. The largely productivity-enhancing export growth and weak domestic demand leave little scope for employment gains. Relatively stronger is the performance of domestic demand in the hard-currency countries, thereby partly offsetting the effects of appreciation on activity. Employment, having fallen markedly less than in the weak-currency countries during the recession, increased steadily, if only moderately, in the early upswing, due to firm domestic demand. Price cuts for imports and the slowdown in domestic inflation contribute towards greater price stability in the hard-currency countries. In the weak-currency area inflationary tendencies, which have so far been reined back by the effects of the past recession, are now becoming increasingly apparent.