Credibility and Interest Rate Discretion in the ERM

Byline: Hali Edison (1), Ronald MacDonald (2) Keywords: exchange rate mechanism; credibility; interest rate linkages; cointegration Abstract: Recent proposals for reforming the international monetary system often focus on a target zone arrangement for the dollar, euro and yen. Theoretical research suggests that a credible target zone confers on a participant some short-run discretion in the setting of interest rates, and recent empirical research suggests that this was indeed the case for the Classical gold standard, perhaps the best example of a credible target zone. In this paper we examine the extent of short-run interest rate discretion (SRID) conferred by another experiment with target zones, namely the ERM experience. Amongst our findings is the result that countries that had a credible commitment to the ERM did indeed have SRID. Author Affiliation: (1) Research Department, International Monetary Fund, Washington, DC, 20431, USA (2) Department of Economics, University of Strathclyde, Glasgow, G41 4PZ, UK Article History: Registration Date: 07/10/2004