Question

• Explain the credibility theory of the EMS.

Answer 1

The history of high inflation in Europe in the 1970s indicates an additional function that the EMS has come to serve. The other EMS countries have also imported the German Bundesbank 's reputation as an inflation fighter and inflation fighter by setting their exchange rates against the DM. The rise of inflationary pressures at home was thus discouraged, pressures they would otherwise have been inclined to satisfy by monetary expansion. This opinion, the EMS 's credibility theory holds that the diplomatic costs of manipulating an foreign exchange rate deal may be beneficial. They will avoid depreciation by governments. To reap the short-term boost of an global downturn at the long-term expense of higher inflation in their currencies. By putting monetary policy decisions in the hands of the inflation-fearing German central bank, policy makers in inflation-prone EMS countries such as Italy have evidently gained legitimacy. There was also a chance of devaluation, but only due to EMS constraints.