DP1190 | Economic Cooperation within Europe: Lessons from the Monetary Arrangements in the 1990s

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The early 1990s marked a distinction between the EMS as a vehicle for creating monetary stability and the EMS as a vehicle for moving towards monetary union. We model that distinction by contrasting policies generated by preference transfers from the lead country (to create the EMS discipline of `tying ones hands') against policies generated by extending the domain of policy-making to Europe-wide targets. We find both solutions to be incentive incompatible compared to simple non-cooperative policy-making, unless the aim becomes the social welfare of Europe as a whole. Various modifications are considered, but incentive compatibility requires some monetary relaxation in order to redistribute the gains. That combines German monetary discipline with differentiated fiscal-monetary mixes for the different economic structures elsewhere in the system. These results are used to explain why wider bands paradoxically provide a more credible route to monetary union.