Monetary policy, the labor market, and pegged exchange rates: A study of the German economy

Abstract

The European Community operated from 1979 to 1999, before the Euro was introduced, under a pegged exchange rate regime, the European Monetary System (EMS). This was also the time period when the European unemployment rate was secularly rising. Germany was the dominant country in Europe and other countries had, to a great extent, to follow Germany’s monetary policy. Kenen (2002) calls this the leader-follower model. On the other hand, German monetary policy, operating under the EMS, was restricted by an open economy dynamic. In the context of a Keynesian open economy macro dynamic model, in the spirit of James Tobin’s work, we explore (1) the implication of pegged exchange rates on the macroeconomic dynamics of a large economy – the German economy, and (2) study how successfully monetary policy can be conducted under pegged exchange rates. A core of our dynamic macro model is an open economy price and wage Phillips-curve. Concerning monetary policy we study two alternative rules: the monetary authority targeting money growth or the inflation rate (Taylor rule). The model is estimated with time series data of the German economy and impulse-response mechanisms explored.