Most analyses of fixed and flexible exchange rates consider a small country deciding unilaterally whether or not to stabilize its exchange rate against the rest of the world. In practice, however, countries fix their rates through mutual agreements in particular on a mutually beneficial allocation of adjustment responsibilities. In Discussion Paper No. 553, Research Affiliate Martin Klein notes that the EMS was originally designed with a `symmetric' allocation of adjustment duties, but it has rapidly evolved into an asymmetric system in which the Bundesbank sets the monetary target and the other members choose between adjustment or realignment. This arrangement is not stipulated by the EMS treaty, so it is evidently a voluntary and mutually beneficial undertaking. A single European currency will automatically force a more symmetric allocation of adjustment duties, and the enhanced cooperation among European central banks envisaged in the Delors Plan is intended to lead the EMS towards greater symmetry; so it is important to understand the conditions that led to this asymmetry in adjustment and the conditions required to re-establish symmetry.

Klein combines a standard macroeconomic model with solution concepts derived from cooperative game theory to consider the joint decision of two countries to form a fixed exchange rate system. They jointly accept the loss of one degree of freedom with respect to their national monetary policies because they expect to reap a cooperation dividend; and if they are able to reach agreement on the distribution of this dividend, the fixed exchange rate system will become established. For realistic parameter values the core of the bargaining game is non-empty, i.e. a mutually beneficial bargaining solution exists, so a fixed exchange rate will usually be preferred by both countries, although there is no guarantee that the allocation of adjustment duties that supports this bargaining solution is symmetric. The transition towards monetary union critically entails the loss of one more degree of freedom in monetary policy and imposes a certain amount of automatic symmetry. The allocation of adjustment duties can therefore no longer be used to sustain the bargaining solution; so if the bargaining solution in the fixed exchange rate system is significantly asymmetric, the countries will not agree to proceed with that transition.

Bargaining for the Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model
Martin Klein

Discussion Paper No. 553, July 1991 (IM)