Monetary Policy and Competitiveness in the Euro Area

  • Francesco Farina
Conference paper


The European Monetary System (EMS) was a fixed exchange rate agreement designed to remove the main obstacle to the creation of that public good which is monetary stability, the high inflation of the countries of Peripheral Europe. Section 3 of this paper analyzes the interest-rate parity condition for a country representative of Peripheral Europe1, showing that the inflation differentials with Germany lay at the foundation of the low degree of credibility attributed to the fixed exchange rates by the market, and pointing to Peripheral Europe’s “currency risk” as the reason why its interest rate differentials with Germany are higher than the depreciation against the DM. In order to reduce the instability that the currencies of Peripheral Europe transmitted to the exchange-rate mechanism (ERM) it was necessary for the monetary authorities of these countries to enjoy the same anti-inflationary reputation as the Bundesbank, thus lending credibility to their disinflation policies. This was the rationale that led the DM to take on the role of nominal anchor of the system. This pivotal role, however, did not imply as its necessary corollary the “asymmetric” working that characterized the European exchange rate mechanism, namely the “hegemonic” solution, instead of the cooperative one, that was given, within the EMS, to the so-called (n — 1) problem, (the autonomy enjoyed by the nth country to join an exchange rate agreement in setting the money supply2).


Exchange Rate Interest Rate Monetary Policy Euro Area Inflation Rate 
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© Springer-Verlag Berlin Heidelberg 2001

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  • Francesco Farina

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