No. 168 - Waiting for EMU: Living with Monetary Policy Asymmetries in the EMS

In an exchange rate system such as the EMS, with full capital mobility and highly credible parities, the ability to use monetary policy to achieve price stability in all countries is diminished in the presence of differentiated domestic inflationary pressures. A country can achieve domestic monetary policy objectives only if it acts as leader of the system and brings the others to accept its policy stance even if it is not optimal for them. Several factors influence the ability of a country to perform the role of leader, such as its size and the credibility of its policies. A further important factor is the position of the currency in the fluctuation band. The design of the EMS makes it easier for countries whose currencies have a strong position within the band to act as leaders. As a consequence, the leadership of the system is likely to be exercised by the countries that have to conduct the most restrictive monetary policies, due for instance to their domestic inflationary pressures or their unbalanced budgetary positions. As a result, the monetary policy of the system will tend to be excessively restrictive.