POLICY-DELEGATION AND FIXED EXCHANGE-RATES

Recent literature interpreting the European Monetary System emphasizes credibility gains from delegating monetary policy to a low-inflation country through fixed exchange rates. This paper presents a model of an exchange rate system as a device for policy delegation in the context of a repeated monetary policy same. In contrast to single-shot games, it generates credibility gains for the high-inflation and low-inflation countries in the system. Credibility gains neither require nor imply hegemony of the low-inflation member. Stochastic realignments enable the members to adopt different inflation trends without destroying the credibility benefits from policy delegation.