The European Monetary System and various tests of policy convergence

Ashok Parikh, David Bailey and David Lovatt

The Journal of International Trade & Economic Development, 1997, vol. 6, issue 1, 43-62

Abstract: It is now widely known that most economic time series of nominal and real exchange rates, money supplies, nominal and real interest rates, price levels and annual rates of inflation possess the property of unit root non-stationarity (stochastic trends). The objective of this paper is to consider whether the establishment of the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) in March 1979 contributed to greater stability in member countries' exchange rates in the 1980s. and led to convergence to lower inflation rates. The analysis of time-series data in a multivariate framework suggests the existence of at least one stable relationship, and possibly two such relationships, in the goods, money and foreign exchange markets. The larger the number of cointegrated vectors for a particular set of variables, the more stable the system and the greater the reduction in the divergence of various indicators from their equilibrium values. We actually find fewer cointegrating vectors in total for the post-1979 period than for the earlier period, though the volatility of both nominal and real exchange rates are lower in the later period. It is, however, likely that the supply side shocks which Europe and the rest of the world experienced during the period 1973-79 could also have increased the relative volatility in indicators in the pre- EMS period as compared to the post-EMS period.

Keywords: Cointegration; divergence indicators; EMS; monetary policy; nominal exchange rates (search for similar items in EconPapers)
Date: 1997
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DOI: 10.1080/09638199700000004

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