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Since the creation of the EMS in 1979 and the Louvre Accord in 1987, economists and policy makers have debated whether exchange rate management can actually secure better economic performance. This paper supplies some empirical evidence to help answer that question in the context of an environment free of unanticipated shocks. Our results identify the important design characteristics of a target zone or EMS type system focusing on the width of the bands, the length of time between realignments, and the choice of exchange rate parity. Secondly we examine the popular “conservation of variance†theory: that reducing exchange rate instability will just cause greater instability in the underlying monetary controls. Finally we produce evidence to support the claim that the method of exchange rate management is important because gross or persistent misalignments cause large welfare losses whereas moderate misalignments would impose only small costs. Work on the EMS relative robustness to shocks is under way. Copyright Kluwer Academic Publishers 1990Exchange Rate Regimes, stability trade-offs, monetary union and cooperation, EMS,

The paper attempts to assess to what extent the central bank or the government should respond to developments that cause …nancial instability, such as housing or asset bubbles, overextended …scal policies, or excessive public or household debt. To analyze this question we set up a simple reduced-form model in which monetary and …scal policy interact, and consider several scenarios with both benevolent and idiosyncratic policymakers. The analysis shows that the answer depends on certain characteristics of the economy, as well as on the degree of ambition and conservatism of the two policymakers. Speci…cally, we identify circumstances under which …nancial instability prevention is best carried out by: (i) both monetary and …scal policy ('sharing'), (ii) only one of the policies ('specialization'), and (iii) neither policy ('indi¤erence'). In the former two cases there are circumstances under which either policy should be more pro-active than the other, and also circumstances under which …scal policy should be ultra-active: ie care about nothing but the prevention of …nancial instability. These results are important in the context of the current crisis. We also show that neither the government nor the central bank should be allowed to freely select the degree of their activism in regard to …nancial instability threats. This is because of a moral hazard problem: both policymakers have an incentive to be insu¢ ciently pro-active, and shift the responsibility to the other policy. Such behaviour has strong implications for the optimal design of the delegation process.

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