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The European Monetary Union as a commitment device for new EU member states

  • Ravenna, Federico

This paper shows 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. 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 fullcredibility 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. JEL Classification: E52, E31, F02, F41

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Paper provided by European Central Bank in its series Working Paper Series with number 0516.

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Date of creation: Aug 2005
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Handle: RePEc:ecb:ecbwps:20050516
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