Anti-inflationary Reputation and Exchange Rate Commitment: The Peseta in the EMS

Abstract

In this paper, we analyse the evolution of the counterinflation reputation implied by joining the exchange rate mechanism of the European Monetary System. We apply a Backus and Driffill (1985a, b) type model where maintaining the existing parity would improve the probability perceived by agents that an existing tough government is in charge. We consider, according to Masson (1995), a concept of credibility that includes the costs of sticking to its policies that any government (tough or wet) must take into account, especially when shocks and government policies have persistent effects on unemployment, and consequently constrain the room for manoeuvre in subsequent periods. The model is tested for the Spanish case over the period 1989-92, using the Kalman filter.