The Advantage of Tying One's Hands: EMS Discipline and Central Bank Credibility

This 1988 European Economic Review paper by Francesco Giavazzi and Marco Pagano asks why a high-inflation country would voluntarily submit to the EMS’s fixed-but-adjustable exchange-rate discipline, and answers that EMS membership can deliver a genuine credibility gain, not merely enforced discipline. In a continuous-time model where a domestic monetary authority faces a standard temptation to generate surprise inflation (to raise output) but also cares about the real exchange rate (hence export-sector profitability), EMS membership attaches an extra, publicly known penalty to inflation – real appreciation that persists until the next realignment – which lowers the policy-maker’s time-consistent (Nash) inflation rate below what a flexible-rate regime would produce. Because the disincentive is common knowledge, it also lowers the inflation the public rationally expects, partly curing the inefficiency that comes from the public’s mistrust of the authorities. Whether EMS participation is a welfare improvement and not merely a cost, however, depends on institutional design: the system must be built so that the competitiveness “bonus” granted at each realignment lies outside the policy-maker’s own control (otherwise the credibility gain vanishes), and the policy-maker’s net incentive to generate inflation surprises, after the discounted real-appreciation penalty, must be sufficiently large; under these conditions the welfare gain is shown to increase the less frequently the country is permitted to realign, and persists (with modification) when capital is perfectly mobile and the real exchange rate is allowed to drift below purchasing-power parity rather than mean-revert to it.

Francesco Giavazzi | Macro Paper Warehouse

The Advantage of Tying One's Hands: EMS Discipline and Central Bank Credibility