No. 186 - Convergence of Inflation, Prerequisite for EMU

This paper assesses the rationale of inflation convergence as a criterion for the passage to the final stage of EMU. It analyzes the consequences of irrevocably fixing exchange rates in the presence of diverging price performances. A simple two-country model is developed to examine the effects of the change in regime under different hypotheses concerning agents' expectations. Simulations are then conducted with the NIESR macroeconometric model. The results suggest that, under certain circumstances, the fixing of exchange rates may produce spillover effects from the high-inflation to the low-inflation country. If the Union's monetary authority seeks to counter these effects, the low-inflation country may suffer a reduction in its output.