Introduction

This study intends to examine the effects of external economic developments on the trade relations and inflation performance of the countries participating in the Exchange-Rate Mechanism (ERM) of the European Monetary System (EMS). The direction of the overall impact on the system of the external factors considered is difficult to assess. On the one hand, the oil shock of 1979–80 and the subsequent dollar appreciation increased inflation in the ERM countries and probably accentuated inflation differentials, thus undermining exchange-rate cohesion. On the other hand, the large real appreciation of most non-ERM currencies vis-a-vis those of the ERM, and the strong recovery of the US economy in the period 1983–5 sustained the growth of economic activity in Europe and may also have contributed to the stability of the exchange-rate system. In this study, we concentrate on this latter aspect, which has not received sufficient attention in the literature on the EMS, and is becoming even more important now since the direction of its development has dramatically reversed.

The study formulates a quantitative framework for the assessment of the effects produced by some of the external factors mentioned above on the trade relations of the three major ERM countries (Germany, France and Italy), with the rest of the ERM area and the other industrial countries. The model outlined in the study is also used to evaluate the implications for trade and inflation of alternative exchange-rate policies and different patterns of aggregate demand growth. However, since the model refers only to the manufacturing sector and is based on a partial equilibrium approach, the findings should be interpreted with caution.