The industrialized world has experienced a variety of international monetary arrangements in the last century. Time- series data for the US and UK suggest that inflation has been generally less persistent and the variance of inflationary shocks much smaller under fixed exchange rates than floating or managed rates. Post-war time-series data for 21 OECD countries confirm this result for inflationary persistence, but they are much less clear regarding the variance of inflationary shocks.

In Discussion Paper No. 503, Research Fellow George Alogoskoufis proposes to explain these discrepancies in two respects. First, forward-looking wage- and price-setters may take account of the increased monetary accommodation of inflationary shocks at the world level, which will increase their persistence through the wage-price spiral. To the extent that the demonetization of gold resulted in higher monetary accommodation in the industrial economies, it led to an increase in the persistence of inflation. Second, a managed rate provides the opportunity for at least a partial accommodation of relative price shocks, which may partly counteract their effects on the real exchange rate and hence on output and employment. Forward-looking wage- and price-setters may again take such accommodation into account, however, and higher persistence of relative inflation shocks will again result through the wage-price spiral.

Alogoskoufis uses an overlapping contracts model to investigate the inflationary process for UK and US monetary and exchange rate policy since 1880 and for the majority of OECD countries in the post-war period. His empirical results suggest that regimes other than the classical gold standard and Bretton Woods have been characterized by greater monetary and exchange rate accommodation and more persistent aggregate and relative inflation rates. These results highlight the effects of monetary and exchange rate regimes on expectations and the nature of wage and price adjustment. They suggest that a credible commitment that price shocks will not be accommodated may be needed to ensure the persistence of low inflation.

Under the classical gold standard and Bretton Woods this credibility was provided by fixed exchange rates and the commitment of the issuer of the main international reserve currency to a fixed price of gold. A non-accommodating monetary policy may also be achieved, however, by independent central banks whose constitutions forbid them to accommodate price shocks or through international cooperation in an world monetary system that does not rest on gold. For example, a fixed exchange rate regime in which monetary policy in the main industrial economies (say the G3) is constrained not to accommodate their average inflation rate may suffice to ensure that inflation does not persist.

Monetary Accommodation, Exchange Rate Regimes and Inflation Persistence
George S Alogoskoufis

Discussion Paper No. 503, January 1991 (IM)