The Advantages of Tying One's Hands: EMS Discipline and Central Bank Credibility

It is often argued that the EMS is an effective disciplinary device for inflation-prone countries in the EEC, since it forces policy-makers in these countries to pursue more restrictive monetary policies than they would otherwise. It is not clear, however, why these countries should submit themselves to such discipline. This paper argues that in order to answer this question appropriately, one must consider that EMS membership brings potentially large credibility gains to policy-makers in high-inflation countries: the reason is that not only it attaches an extra penalty to inflation (in terms of competitiveness losses), but makes the public aware that the policy-maker is faced with such penalty, and thus helps to overcome the inefficiency stemming from the public's mistrust for the authorities. We study the conditions under which these credibility gains are larger than the penalties that the policy-maker incurs in equilibrium. When policy-makers attach no value to inflationary finance, we find that they will always prefer EMS membership. When the policy-maker needs revenue from the inflation tax, however this conclusion is not always true. The opposite contention, that EMS membership is an inferior regime for any government that needs inflationary finance is also generally incorrect. The outcome of the welfare comparison depends (i) on the value placed by the policy-maker on seigniorage relative to the discounted output cost of inflation, and (ii) on the tightness of EMS discipline, as measured by the time interval between realignments and by the portion of lost competitiveness that the country is not allowed to recover at realignments.