Monetary Policy in Stage Two of EMU: What Can We Learn From the 1980s?

A smooth progression from Stage Two to Stage Three of EMU requires that the type of policy planned for Stage Three should be foreshadowed in Stage Two. Two possibilities for that policy are monetary targeting or an interest rate policy feeding back on a nominal variable. The paper re-examines the evidence of the 1980s to determine the nature and stability of reduced form relationships involving money and interest rates. Geweke linear feedback measures are presented for a subset of the G7 countries (France, Germany, Italy, the United Kingdom and the United States). Greater stability is found in relationships involving money than expected, while interest rate leads, though significant, are often at long lags. In addition, aggregate ERM money demand functions are shown to be stable. These results, though not conclusive, provide support for the case for monetary targeting.