EMS
Free Bundesbank For Each New Member

The exchange rate mechanism of the European Monetary System (EMS) is a cooperative arrangement to fix exchange rates, with periodic realignments in response to differences in inflation rates. Since membership is voluntary, we should expect member countries to benefit from the EMS. In Discussion Paper No. 178, Research Fellow Jacques Melitz examines the popular argument that attributes this benefit to the monetary discipline that joint membership with the Federal Republic of Germany imposes on other EMS members. This hypothesis has two attractive features. First, it explains the dominant position of Germany within the EMS. Second, it is consistent with the evidence that membership has induced several countries to disinflate more than they might otherwise. Melitz finds the hypothesis insufficient, however, to explain why countries other than Germany would prefer to remain in the EMS instead of finding alternative means of acquiring monetary discipline.

Melitz specifies a two-country macroeconomic model: one country can be thought of as Germany and the other as France. Deviations of output from its natural rate are determined by 'inflation surprises'; i.e. the difference between the domestic rate of inflation and the public's expectation of it. Inflation depends on the other country's rate of inflation of producer prices and the rate of change of the exchange rate as well as domestic producer-price inflation. Each government sets its monetary policy instrument (which determines the rate of inflation) so as to minimize a discounted stream of social costs, which reflect the inflation rate and the discrepancy between actual and natural output. The two countries are identical, except in the degree to which their governments discount the future in choosing their policies. Melitz assumes that the German central bank is independent of the government, while the French central bank is not and therefore must take into account election dates. As a result, the French central bank uses an appreciably higher discount rate than the German.

EMS membership imposes costs: these include the need for capital controls, the loss of reserves necessary to keep the exchange rate fixed between realignments, and political unpopularity when devaluation takes place. These costs consist of both fixed costs associated with membership and variable costs, which rise with domestic inflation. Variable costs help impose monetary discipline since they penalize higher inflation; fixed costs do not. The attraction of membership as a means of countering inflation depends on the balance between these two costs.

If EMS realignments take place only every second period the conditions under which EMS membership would benefit France are very stringent. Since the exchange rate is fixed for a longer period, expansionary monetary policies are more tempting because import prices are temporarily constrained. If the authorities discount future costs heavily, they may adopt expansionary policies: the variable costs of EMS membership having fallen, the discipline of membership is reduced. Melitz also argues that even if France did benefit from greater monetary discipline, the same benefits could be obtained outside the EMS at lower cost by the reform of domestic monetary institutions.

The monetary discipline interpretation of the EMS also fails to explain the benefits which Germany might derive from EMS membership. As a result, Melitz concludes, it is seriously incomplete as an explanation of the EMS.

Monetary Discipline, Germany, and the European Monetary System
Jacques Melitz

Discussion Paper No. 178, April 1987 (IM)