In recent years, European Monetary System (EMS) countries have pegged their exchange rates to the deutsche mark in an attempt to reduce their inflation to German levels. Although there have been no realignments since 1987, inflation rates have nevertheless been slow to adjust. This paper examines three possible reasons for a sluggish inflation response such as that observed in the EMS.
In the first part of the paper, the role of overlapping contracts is examined. While some inflation persistence does arise when contracts are of the Taylor type, the period of persistence following the switch to a fully credible exchange rate peg is never longer than the contract; and overlapping contracts of random length, as described by Calvo, are found to generate no inflation persistence at all.
In the second part of the paper, lack of full credibility of the peg is allowed for by assuming that the private sector expects random realignments of the exchange rate. For convenience, the model with Calvo contracts is used, which implies that all the inflation inertia must come from this lack of credibility. How fast inflation adjusts depends on how quickly people come to believe the exchange rate peg.
The third section of the paper analyzes the idea that inertia in inflation during a stabilization program might be due to a lack of “common knowledge.” The usual rational expectations assumption is weakened by supposing that each agent fully believes in the peg but assumes that other agents do not and will take time to learn. The paper concludes that while inflation inertia may arise from this lack of common knowledge, it is less than indicated in Section 2 (because each agent knows the true path of the actual exchange rate).