Currency Crises and Political Factors: Drawing Lessons from the EMS Experience

Francisco Pérez-Bermejo and Simon Sosvilla-Rivero

No 2004-04, Working Papers from FEDEA

Abstract: This paper analyses the functioning of the European Exchange Rate Mechanism (ERM). To that end, we apply the duration model approach to estimate an eclectic model that enables us to explicitly incorporate political and institutional factors into the explanation of European exchange rate policies. The estimation is based on quarterly data of eight currencies participating in the ERM, covering the complete European Monetary System (EMS) history. Our results suggest that both economic and the political factors are important determinants of ERM currency policy. On the one hand, the real exchange rate, the interest differentials and the central parity deviation would have negatively affected the duration of a given central parity, while credibility, the level of international reserves and the price level in the anchor country would have positively influenced such duration. On the other hand, elections, central bank independence and left-wing government increase the probability of maintaining the current regime, while unstable governments would have been associated with a regimen change.

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