EMS
Deflated expectations

It is often argued that the EMS is an effective disciplinary device since it forces policy-makers in inflation-prone countries to pursue more restrictive monetary policies. It is less clear, however, why these countries should submit themselves to such discipline. In Discussion Paper No. 135, Research Fellows Francesco Giavazzi and Marco Pagano emphasize the credibility gains that EMS membership brings to policy-makers in high- inflation countries. The authors note that EMS members with above-average rates of inflation have experienced steady losses in competitiveness. The private sector knows that policy-makers, faced with such a penalty to inflation, are less likely to renege on anti-inflationary policies. This adds credibility to the actions of policy-makers and can lead to an equilibrium with lower inflation.

Giavazzi and Pagano study the conditions under which this increased credibility is more attractive to policy-makers than the loss of competitiveness. When policy-makers attach no value to inflationary finance, for example, they will always prefer EMS membership. When the policy-maker needs revenue from the inflation tax, however, this is not always true. Giavazzi and Pagano find that the attractions of membership depend on the value placed by the policy-maker on seigniorage relative to the discounted output cost of inflation, and on the tightness of EMS discipline, as measured by the time interval between realignments and by the portion of lost competitiveness that the country is not allowed to recover at realignments.

A fuller discussion of the EMS can be found in the report in this Bulletin of a recent lunchtime talk by Francesco Giavazzi.


The Advantage of Tying One's Hands: EMS Discipline and Central Bank Credibility
Francesco Giavazzi and Marco Pagano

Discussion Paper No. 135, October 1986 (IM)