Working Paper: CEPR ID: DP774
Authors: Patrick Minford
Abstract: Since the establishment in 1979 of the Exchange Rate Mechanism of the EMS a number of countries, after entry, have experienced a substantial and persistent rise in their real exchange rate (the ratio of domestic to foreign prices). This paper explains this phenomenon in terms of a `peso problem' of credibility created by the response of a member government to the incentives it faces within the ERM.A country within the ERM that attempts to restrain inflation and avoid economic distortions faces strong pressure from its domestic manufacturing lobby. In the event that trading conditions for manufacturers worsen drastically, they will apply intense pressure not only for subsidy protection but also for a devaluation. When times are good, however, the pressure will be relaxed. This creates an asymmetry in the government's policy reaction: devaluation and subsidy in bad times, and no parity change or subsidy in good times. The result is an average expectation of devaluation in excess of what normally occurs which leads to overvaluation in normal times.
Keywords: EMU; Optimal Currency Area; Micro Foundations; Peso Problem; Real Exchange Rate; Exchange Rate Overvaluation
JEL Codes: E42; E52; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Domestic manufacturing pressure (L69) | Government response (H12) |
| Government response (H12) | Wage contracts (J41) |
| Wage contracts (J41) | Increased prices in non-traded goods (H49) |
| Increased prices in non-traded goods (H49) | Higher real exchange rates (F31) |
| Domestic manufacturing pressure (L69) | Higher real exchange rates (F31) |