EMS and anti-inflationary performance

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Credibility and inflation

• much higher risk of breaking out of the fixed exchange rate where there are different currencies – especially as realignments were permitted
• speculators know Governments have devaluation as a policy instrument, and expect it when there has been a shock – even if this means reneging on a commitment to fixed exchange rates
• if the government has low credibility (and it traditionally has high inflation e.g. Italy) then it is now more credible to announce fixed exchange rates than announcing low inflation

EMS and inflation

• Leader country (Germany) sets monetary policy
• n countries, n-1 degrees of freedom (n-1 countries which cannot use monetary policy because they have to use it to maintain the target exchange rate)
• Source of conflict because Germany could set interest rates at a level for its own benefit rather than for the EMS area as a whole

Exchange rate and central bank regimes: leadership within the EMS

Hegemonic

• one country set the monetary policy and the other country sets interest rates the same, duplicating policy
• good – central bank of periphery country has to be very disciplined – a monetary expansion quickly has to be reversed as money will flow out to the higher interest rate centre country
• bad – in recession interest rates fall (reduced demand for money), money flow to centre country with higher interest rates, inflation is met by sterilisation (sales of securities)

Symmetric (co-operative)

• both countries decide policy together with a neutral central bank
• this was the original aim of the EMS with the ECU as the neutral unit of currency to measure divergence – country whose currency deviated too much would have to take action using monetary policy
• using the other country’s currency means the corrective policy is symmetrical
• this was not effective in practice – central bank of weak country would sell (strong) Deutschmarks – interest rates would fall, so the Bundesbank would have to act to sterilise by buying the marks back through open market operations

Which country should be leader?

• country with lowest inflation rate will spread that to followers, so the lowest inflation country as the leader maximises welfare
• also it needs to have a reputation for low inflation
• side effect: other members (e.g. Italy) who have typically higher inflation have to increases unemployment to keep to the low inflation rate