Inflation Convergence with Realignments in a Two-Speed Europe

In the first decade of its existence the EMS passed through three phases of realignments: full accommodation, partial accommodation and zero accommodation of inflation differentials. To what extent, however, does the new freedom of capital movements within the EC rule out such gradual convergence with realignments for new members? This paper uses a model with forward-looking behaviour in labour and financial markets to analyse this question. A rule which partially accommodates inflation differentials is shown to be consistent with inflation convergence and perfect capital mobility, provided that the timing of realignments is stochastic and the rule is fully credible.