One of the most important tasks for virtually all central banks, including Danmarks Nationalbank, is to ensure stable price development. Stable prices and low inflation are prerequisites for a robust economy.
Roughly, the price level in a society depends on supply and demand. Prices rise if the demand for goods and services exceeds the supply - or vice versa. Inflation means an increase in the general price level, i.e. the prices of a wide range of goods are rising year-on-year.
Ensuring stable price development in Denmark
Supply and demand are influenced by several actors and various types of policies.
Fiscal and structural policies are adopted at political level in the Danish Parliament. Fiscal policy basically covers measures affecting economic activity through government revenue and expenditure, such as taxes and public spending, while structural policy covers measures affecting economic framework conditions, such as the framework of the labour market. The money that the central government channels to society in this way can impact supply and demand. Danmarks Nationalbank continuously analyses the Danish economy and can make fiscal policy recommendations. This is most often done in the analyses ‘Outlook for the Danish economy’, which is published every year in March and September.
Central banks such as Danmarks Nationalbank is resposible for monetary policy. Monetary policy is about adjusting interest rates in order to influence how expensive or cheap it is for individuals and companies to borrow for consumption and investment, which is another way of influencing supply and demand.
Since the beginning of the 1980s, Denmark has chosen not to use monetary policy, i.e. interest rates, to directly control the domestic economy and the cyclical situation. Instead, we are pursuing a fixed exchange rate policy using interest rates exclusively to maintain a fixed krone rate against the euro. Ultimately, the goal is the same: to ensure stable prices and stable inflation expectations. But the path to that end and the measures to be applied in practice are different.
The overall economic policy – fixed exchange rate policy and fiscal policy – has contributed to a stable economic development in Denmark.
Fixed krone rate by means of interventions and interest rate adjustments
Danmarks Nationalbank has two main tools for keeping the krone rate stable against the euro: interventions in the foreign exchange market and interest rate adjustments. In addition, the substantial credibility of the fixed exchange rate policy in itself contributes to stable development of the krone.
Danmarks Nationalbank monitors the Danish krone exchange rate closely, always ready to step in – or intervene, as it is called – if needed. If the krone exchange rate begins to deviate too much from the euro, Danmarks Nationalbank can choose to buy or sell kroner and thus restore the krone rate against the euro. Buying and selling krroner affects the size of the foreign exchange reserve.
For certain types of pressures against the krone, e.g. by speculative attacks, interventions for substantial amounts could be the response. During the great krone pressure in January and February 2015, Danmarks Nationalbank intervened for kr. 275 billion. In the event of minor or short-lived krone fluctuations, interventions for relatively modest amounts may be sufficient.
Once a month, Danmarks Nationalbank publishes the extent of intervention in the foreign exchange market in the past month.
When Danmarks Nationalbank wants to affect the krones exchange rate against the euro, it will initially start buying or selling kroner. Subsequentely, Danmarks Nationalbank can affect the krones exchange rate against the euro by adjusting the monetary policy interest rates, i.e. the interest rates on the various types of deposits and loans (called monetary policy instruments) that Danmarks Nationalbank offers to the large banks (monetary policy counterparties).
An increase of the Danish interest rate relative to the interest rate in the euro area member states will make it more attractive to invest in kroner than in euro, and the increasing demand for Danish kroner will strengthen the krone. Conversely, investment in kroner can be made less attractive by reducing the Danish deposit rate relative to that of the euro area in order to weaken the krone.
The current interest rates can be viewed at any time here on Danmarks Nationalbank’s website. Any decision on an interest rate adjustment will be announced via a press release outside the opening hours of the foreign exchange markets.
Why is the euro the chosen currency of our fixed exchange rate policy?
Throughout the 1970s, interest rates and inflation were high and the balance of payments and public finances posted large deficits. On several occasions, the government in office applied devaluations in an attempt to improve competitiveness, but without success. The result was high inflation.
Since 1982, Denmark has pursued a fixed exchange rate policy against first the D-mark and later the euro after its introduction in 1999.
In the euro area, the European Central Bank, ECB, aims to keep inflation close to 2 per cent over the medium term. By keeping the krone stable against the euro, Danmarks Nationalbank seeks to mirror the ECB and achieve the same low and stable inflation in Denmark.
The choice of the euro for the fixed exchange rate policy is motivated by Denmark’s substantial trade with the euro area. As a large share of Denmark’s total exports and imports takes place to and from the euro area, any difference in price developments between Denmark and the euro area will quickly affect the competitiveness of Danish companies, which will impact unemployment in Denmark – and thus demand – so that prices in Denmark will again approach the level in the euro area. By fixing the krone exchange rate against the euro, the price development in Denmark will follow the price development in the euro area.
Today’s fixed exchange rate policy and ERM II monetary cooperation
When the euro was introduced in 1999, Denmark joined the Exchange Rate Mechanism II (ERM II) as a non-euro area member state. ERM II is still the formal framework for Denmark’s fixed exchange rate policy.
Denmark participates in ERM II at a central rate of kr. 746.038 per 100 euro. The central rate, converted from the previous exchange rate against the D-mark, is Danmarks Nationalbank’s aimed krone exchange rate.
The fluctuation band in ERM II is +/- 15 per cent, but Denmark has entered into an agreement with the ECB and the euro area member states on a narrower fluctuation band of +/- 2.25 per cent. This allows the krone to fluctuate between kr. 762.824 and 729.252 per 100 euro at most. Since the end of the 1990s, Danmarks Nationalbank has stabilised the krone exchange rate close to the central rate.
About ERM II
The euro is at the heart of ERM II, and the currencies of the participating member states have central rates against the euro, but not against each other. The obligation to intervene, i.e. to purchase or sell currency in support if a participating currency moves to one of the fluctuation limits, rests solely with the central bank of the relevant member state and the ECB. The other participating member states have no obligation to intervene. The volume of interventions is unlimited.
One of the criteria for joining the euro area is that the member state must observe the normal fluctuation band of +/- 15 per cent without serious tensions for at least two years. The applicant member state must not have devalued its currency against the euro during the same period. Besides this,the applicant member state must meet the so-called convergence critria.