Exchange Rates
A two-speed Europe?

Inflation convergence in the EMS has been accompanied by currency realignments, which appear to have fallen into two phases: in 1979-83, realignments fully accommodated inflation differentials; while in 1983-7, realignments only partially accommodated these differentials. The liberalization of capital flows has greatly increased capital mobility. Large and predictable realignments may therefore lead to speculative attacks. Many therefore argue for an irrevocable commitment to the current parities, but for some countries this is simply not credible. An alternative is a `two-speed Europe', with an inner core moving promptly to `joint monetary decision-making and zero margins', leaving the other countries subject to much looser links.
In Discussion Paper No. 597, Luisa Lambertini and Research Fellows Marcus Miller and Alan Sutherland investigate the functioning of such a two-speed Europe, using a continuous-time model with inertia in the aggregate price level. The current price level is an average of all outstanding wage contracts and the current new wage contract a function of expected future prices and demand. They also include an international arbitrage equation that relates the exchange rate's expected rate of change to the difference between domestic and foreign nominal interest rates. Aggregate demand depends on the real interest rate and competitiveness; the probability of exchange rate realignment is constant, and this is common knowledge.
Their analysis confirms that expectations of a realignment will affect current contracts and increase inflationary pressure. In particular, a realignment rule that preserves competitiveness will lead to continuous inflation and depreciation; but a partial accommodation rule is consistent with inflation convergence. Such a rule can be implemented with rational expectations in labour and financial markets and perfect capital mobility.
Lambertini, Miller and Sutherland argue that the Italian experience of operating a wider band suggests that convergence without a formal realignment is unlikely. The Italian monetary authorities operated within much narrower bands, which they could reposition without consulting partner countries. They did not use the wider band to accommodate a crawling peg for the lira, but rather to signal their commitment to bringing inflation down to the prevalent level in the core countries, while they gained experience of holding the rate within much narrower margins that could still be realigned as required. The authors focus on very narrow margins of fluctuation from the current EMS parities in order to highlight the problems of high capital mobility in a two-speed Europe. They also discuss the use of wider bands as a substitute for or complement to stochastic realignments.

Inflation Convergence with Realignments in a Two-Speed Europe
Luisa Lambertini, Marcus Miller and Alan Sutherland

Discussion Paper No. 597, December 1991 (IM)