The reduced frequency of exchange rate realignments among ERM members since 1987 and the expansion of its membership have been accompanied by discussion of the world economy's evolution into three `currency blocs' based on the Deutschmark, yen and dollar. In Discussion Paper No. 711, Tamim Bayoumi and Research Fellow Mark P Taylor use data on eight major industrial economies to investigate the effects of ERM membership on macroeconomic performance and measure any such trend towards policy independence in Germany, Japan and the US. They compare the behaviour of ERM members and non-members before and after its inauguration using the BlanchardQuah VAR methodology to identify both the underlying aggregate demand and supply shocks, which have permanent and temporary effects on real output respectively, and governments' policy responses.

In their model, a positive demand shock induces a short-term rise in output, which gradually returns to its initial level, and a permanent rise in prices; a positive supply shock leads to permanent increases in output and reductions in prices. By limiting exchange rate flexibility, the ERM may cause member economies' performance to converge, if their responses to shocks become more correlated as coordination increases, the shocks themselves become more correlated, or their spillover effects increase. ERM membership may also affect the mix of different shocks or elongate policy responses.

Bayoumi and Taylor find that the correlations of responses among ERM members appear to have increased relative to the levels of the 1970s and are higher than those among non-ERM members in the 1980s. There is little evidence that the ERM either influenced, or was influenced by, the underlying shocks, but it may have affect their impact. Except in Japan and the US, the percentage of price variation due to demand shocks fell during the 1980s, while there was a corresponding rise in the variation of output. The authors finally consider the `tri-polarity' hypothesis, which suggests that the feedback of shocks among the G3 economies should have diminished. They find that the underlying aggregate demand disturbances have become more independent over time, suggesting that the interdependence of their macroeconomic policies has indeed fallen, as the tri-polarity hypothesis suggests.

Macroeconomic Shocks, the ERM and Tri-Polarity
Tamim A Bayoumi and Mark P Taylor

Discussion Paper No. 711, September 1992 (IM)