Introduction

In 1978, the year before the European Monetary System (EMS) was instituted, (CPI) inflation among the prospective members averaged 7.2 per cent. The rates ranged from 2.7 per cent in Germany to 12.0 per cent in Italy. Inflation rates rose even further during 1979–80, as a result of the second oil shock. By the end of 1986, average EMS inflation had fallen to 2.4 per cent, and the range had narrowed considerably: – 0.2 per cent in Germany and 5.9 per cent in Italy. The timing of these developments suggests what I will call the ‘EMS-Inflation Hypothesis’ – that the EMS itself may have been responsible for the inflation reduction and convergence which member countries have experienced.

There seems to be growing consensus that the EMS-inflation hypothesis is true. To give two examples, the Wall Street Journal recently stated without qualification that ‘the EMS has had its successes, such as helping to bring inflation in the other countries down toward the low level prevailing in West Germany’ (8 September 1987). Giavazzi and Pagano (1986) assert that ‘the central issue is not whether the EMS is an effective disciplinary device for inflation-prone countries … It is obvious that their inflation will be lower inside than outside the EMS’.

In contrast, early studies of the EMS found little evidence supporting the hypothesis. Rogoff (1985a) analyses data through March 1984.