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The Political Economy of the Exchange Rate Mechanism

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  • Minford, Patrick

Abstract

Since the establishment in 1979 of the Exchange Rate Mechanism of the EMS a number of countries, after entry, have experienced a substantial and persistent rise in their real exchange rate (the ratio of domestic to foreign prices). This paper explains this phenomenon in terms of a `peso problem' of credibility created by the response of a member government to the incentives it faces within the ERM.A country within the ERM that attempts to restrain inflation and avoid economic distortions faces strong pressure from its domestic manufacturing lobby. In the event that trading conditions for manufacturers worsen drastically, they will apply intense pressure not only for subsidy protection but also for a devaluation. When times are good, however, the pressure will be relaxed. This creates an asymmetry in the government's policy reaction: devaluation and subsidy in bad times, and no parity change or subsidy in good times. The result is an average expectation of devaluation in excess of what normally occurs which leads to overvaluation in normal times.

Suggested Citation

  • Minford, Patrick, 1993. "The Political Economy of the Exchange Rate Mechanism," CEPR Discussion Papers 774, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:774
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    1. Francesco Giavazzi & Marco Pagano, 1991. "The Advantage of Tying One's Hands: EMS Discipline and Central Bank Credibility," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 303-330, National Bureau of Economic Research, Inc.
    2. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
    3. Phelps, Edmund S & Taylor, John B, 1977. "Stabilizing Powers of Monetary Policy under Rational Expectations," Journal of Political Economy, University of Chicago Press, vol. 85(1), pages 163-190, February.
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    Cited by:

    1. Pierre Siklos & Rod Tarajos, 1996. "Fundamentals and devaluation expectations in target zones: Some new evidence from the ERM," Open Economies Review, Springer, vol. 7(1), pages 35-59, January.
    2. Mireille Linjouom, 2004. "The Costs and Benefits Analysis of CFA Membership: The Choice of an Exchange Rate Regime for the CFA Countries Zone," WIDER Working Paper Series RP2004-14, World Institute for Development Economic Research (UNU-WIDER).

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    More about this item

    Keywords

    EMU; Exchange Rate Overvaluation; Micro Foundations; Optimal Currency Area; Peso Problem; Real Exchange Rate;
    All these keywords.

    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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