Inflation Convergence with Realignments in a Two-Speed Europe.

In the first decade of its existence, the European Monetary System passed through three phases of realignments: full accommodation, partial accommodation, and zero accommodation of inflation differentials. But to what extent does the new freedom of capital movements rule out such gradual convergence with realignments for new members? This paper uses a model with forward looking behavior in labor and financial markets to analyze this question. A rule which partially accommodates inflation differentials is shown to be consistent with inflation convergence and perfect capital mobility, provided the timing of realignments is stochastic and the rule is fully credible. Copyright 1992 by Royal Economic Society.