The fixed exchange rate policy and its constraints

Denmark has pegged its krone to the euro, and before that to the Deutsche mark, continuously since joining the European Exchange Rate Mechanism II on January 1, 1999, maintaining a central rate of 7.46038 kroner per euro within a narrow 2.25 percent band. Danmarks Nationalbank's own explanation of the framework is blunt about the tradeoff involved: because capital moves freely across Danish borders, the peg can only hold if Danish interest rates move in lockstep with whatever the anchor country, now the euro area, is doing, which means the central bank's policy rate is reserved entirely for defending the exchange rate rather than for managing domestic demand. That constraint is why Denmark's interest-rate chart tracks the European Central Bank's so closely over four decades of varying domestic conditions, and why Danish business-cycle and inflation charts instead reflect fiscal policy, housing credit conditions and global demand far more than any independent monetary stance, a structural feature that distinguishes Denmark from freely floating economies of similar size.