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The European Monetary Union as a Commitment Device for New EU Member States

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Abstract

We show that the credibility gain from permanently committing to a fixed exchange rate by joining the European Monetary Union can outweigh the loss from giving up independent monetary policy if the domestic monetary authority does not enjoy full credibility. Using a DSGE model, this paper shows that when the central bank enjoys only limited credibility a pegged exchange rate regime yields a lower loss compared to an inflation targeting policy, even if this policy ranking would be reversed in a full-credibility environment. There exists an initial stock of credibility that must be achieved for a policy-maker to adopt inflation targeting over a strict exchange rate targeting regime. Full credibility is not a precondition, but exposure to foreign and financial shocks and high steady state inflation make joining the EMU relatively more attractive for a given level of credibility. The theoretical results are consistent with empirical evidence we provide on the relationship between credibility and monetary regimes using a Bank of England survey of 81 central banks.

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Bibliographic Info

Paper provided by Oesterreichische Nationalbank (Austrian Central Bank) in its series Working Papers with number 98.

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Date of creation: 12 May 2005
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Handle: RePEc:onb:oenbwp:98

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Keywords: Inflation targeting; Credibilty; Open Economy; Exchange Rate Regimes; Monetary Policy;

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Citations

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Cited by:
  1. Lipinska, Anna, 2008. "The Maastricht Convergence Criteria and Monetary Regimes for the EMU Accession Countries," MPRA Paper 16375, University Library of Munich, Germany.
  2. Anna Lipinska, 2007. "The Maastricht Convergence Criteria and Optimal Monetary Policy for the EMU Accession Countries," CEP Discussion Papers dp0808, Centre for Economic Performance, LSE.
  3. Anna Lipinska, 2006. "Monetary regime choice in the accession countries - a theoretical analysis," Computing in Economics and Finance 2006 243, Society for Computational Economics.
  4. Lipinska, Anna, 2008. "The Maastricht Criteria and Optimal Monetary and Fiscal Policy Mix for the EMU Accession Countries," MPRA Paper 16376, University Library of Munich, Germany.

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