Introduction

In recent years, countries in the European monetary system (EMS) have pegged their exchange rates to the Deutschmark in an attempt to reduce their inflation to German levels. Although there have been no realignments since 1987, inflation rates have been slow to adjust. Indeed, from the evidence of European inflation indices over the period 1987–91, the authors of the report on monitoring European integration (CEPR 1991) concluded: ‘There is no doubt … that inflation convergence has not occurred and it is not occurring. The differential between higher-inflation countries and Germany has recently fallen; but this has been almost entirely due to a surge in the German inflation rate which is believed to be temporary’. We examine three possible reasons for the sluggish inflation response observed in the EMS.

Some observers have stressed the role of staggered wage setting in perpetuating inflation and have recommended synchronizing pay settlements as an institutional solution, see for example Layard (1990). This chapter begins, therefore, with an investigation of the link between inflation persistence and overlapping contracts in the rational expectations models of John Taylor and Stanley Fischer (where wage settlements are for two periods, but two groups alternate in making settlements). We do find some inflation persistence, but only for one period.