DP774 | The Political Economy of the Exchange Rate Mechanism

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Publication Date

31/03/1993

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Abstract

Since the establishment in 1979 of the Exchange Rate Mechanism of the EMS a number of countries, after entry, have experienced a substantial and persistent rise in their real exchange rate (the ratio of domestic to foreign prices). This paper explains this phenomenon in terms of a `peso problem' of credibility created by the response of a member government to the incentives it faces within the ERM.A country within the ERM that attempts to restrain inflation and avoid economic distortions faces strong pressure from its domestic manufacturing lobby. In the event that trading conditions for manufacturers worsen drastically, they will apply intense pressure not only for subsidy protection but also for a devaluation. When times are good, however, the pressure will be relaxed. This creates an asymmetry in the government's policy reaction: devaluation and subsidy in bad times, and no parity change or subsidy in good times. The result is an average expectation of devaluation in excess of what normally occurs which leads to overvaluation in normal times.