Working Paper: NBER ID: w2539
Authors: Maurice Obstfeld
Abstract: Current and planned measures liberalizing the external capital accounts of France and Italy call into question the continued viability of the policy of periodic exchange-rate realignment followed to date in the European Monetary System (EMS). This paper is intended as a first step in studying the real and monetary effects of EMS-style realignments in a setting of free cross-border financial flows. The first set of results derived concerns a situation in which there are no fundamental factors behind domestic inflation. Under a policy regime in which domestic inflation automatically triggers devaluation, the economy can undergo self-fulfilling depreciation-inflation spirals, triggered by speculative attack on the exchange rate. Such spirals do not occur when realignments do not offset past inflation fully. The second set of results shows how an exchange rate collapse can occur after inflation is set off by expansionary fiscal policy. Sometimes, but not always, the crisis will be preceded by a period of capital inflows and real currency appreciation. In other cases fiscal expansion may set off an immediate crisis.
Keywords: exchange rates; speculation; inflation; European Monetary System
JEL Codes: F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Expectation of realignment (D84) | Speculative attacks (D84) |
| Speculative attacks (D84) | Depreciation (D25) |
| Expectation of realignment (D84) | Depreciation (D25) |
| Failure to adequately adjust exchange rate (F31) | Crisis (H12) |
| Realignment perceived to maintain competitiveness (F12) | Stabilization of the economy (E63) |