DP502 | The European Monetary System: Achievements and Survival

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The EMS's robustness in the face of stochastic shocks is studied, using the Liverpool World Model and the optimal strategy algorithm of Brandsma and Hughes Hallett. The EMS began life in 1979 with a system design permitting regular parity changes; we find this design to be relatively unstable, even without monetary policy reaction, and potentially highly unstable under Nash non-cooperative monetary policy, essentially because EMS countries that should be followers make over-active use of monetary policy and parity changes. Tough exchange controls (clearly some temporary controls are a practical requirement for EMS survival in times of parity crisis) do not reduce instability, indeed can make it worse. However, monetary cooperation between EMS member removes much of the instability for EMS members; limiting parity change on its own does not help. Floating with non-cooperative monetary policy remains more stable than any EMS regime, for both the EMS and non-EMS groups of countries. The paper offers an explanation, based on institutional survival and evolution, of the changes in the EMS's mode of operation since 1979.