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Credibility costs in the monetary integration game

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  • Damien Besancenot
  • Radu Vranceanu

Abstract

Euro candidates are expected to maintain the value of their currency within the fluctuation band of the new exchange rate mechanism for at least two years. This paper highlights some unpleasant macroeconomic effects that could occur during this interval. The problem is cast as a two-stage sequential game between private agents and the government of the applicant country. The policy-maker decides whether to devaluate the domestic currency or not at two distinct dates; it makes a last choice just before accession to the monetary union. Under an assumption of incomplete information of private agents about the government's priorities on inflation and economic activity, the game presents a hybrid perfect Bayesian equilibrium. In the pooling configuration, an initial policy of zero devaluation does not signal the final devaluation decision. As private agents cannot completely rule out the risk of a 'last devaluation', a premium adds to interest rates and entails a systematic output loss. Copyright (c) The European Bank for Reconstruction and Development, 2003..

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Article provided by The European Bank for Reconstruction and Development in its journal The Economics of Transition.

Volume (Year): 11 (2003)
Issue (Month): 4 (December)
Pages: 727-741

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Handle: RePEc:bla:etrans:v:11:y:2003:i:4:p:727-741

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