Working Paper: CEPR ID: DP518
Authors: Maurice Obstfeld
Abstract: This paper studies the merits of policy rules with escape clauses, analysing as an example fixed exchange rate systems that allow member countries the freedom to realign in periods of stress. Motivating this example is the debate within the European Monetary System over how quickly to move from the current regime of national currencies, linked by pegged but adjustable exchange rates, to a single European currency. The paper's main point is that while well-designed rules with escape clauses can raise society's welfare in principle, limited credibility makes it difficult for governments to implement such rules in practice. An EMS-type institution which presumably imposes a political cost on policy-makers who realign may lead to an optimal escape-clause equilibrium, but may just as well lead to alternative equilibria far inferior to an irrevocably fixed exchange rate. Countries can suffer periods in which no realignment occurs, yet unemployment, real wages, and ex post real interest rates remain persistently and sub-optimally high.
Keywords: realignment; escape clause; credibility; european monetary system
JEL Codes: 431
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| escape clauses (Y60) | unemployment rates (J64) |
| escape clauses (Y60) | real wages (J31) |
| escape clauses (Y60) | real interest rates (E43) |
| EM-type institution (E02) | optimal escape-clause equilibrium (D51) |
| EM-type institution (E02) | inferior equilibria (D59) |
| policy rules with escape clauses (E60) | societal welfare (I38) |
| currency depreciation (F31) | employment above natural rate (J68) |
| high unemployment (J64) | suboptimal economic conditions (E66) |