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R>outcome is higher inflation because the public,
assuming rational expectations, will anticipate
the policy. Wet-c some credible mechanism,
such as a monetary rule, in place the expansionarv
policy would not he implemented. Alternativelv,
a commitment to a fixed exchange rate
through a pledge to maintain gold convertibility,
for example could achie~’ethe same results, hut
because it is more transparent, it would possibly
cost less. 10 Such binding commitments may, however,
be undesir-ahle in the presence of extreme
emergencies such as major wars, supply shocks
or financial crises.11 Undet- such circumstances
~Thisresult is disputed by Mettzer and Robinson (1989).
4The Group of Seven countries are Canada, France, Germany,
Italy, Japan, the United Kingdom and the United
States.
5Eichengreen followed the methodology of Baxter and
Stockman (1989).
tSimilarty a monetary union such as the proposed European
Monetary Union could provide effective insulation
from common supply shocks for its members. However,
giving up monetary independence imposes additional burdens
in the case of member-specific (regional) shocks,
Feldstein (1992).
7Addressing the issue of the optimum currency area, Bayoumi
and Eichengreen (1992b, 1992c and 1992d) also
apply this methodology to examine the incidence of
shocks within Western Europe and within regions of North
America.
8See Kydland and Prescott (1977), Barro and Gordon
(1983), and Persson and Tabellini (1990).
9Alternatively the monetary authority may create an inflation
surprise to offset a labor market distortion that raises the
unemployment rate above some desired level.
105ee Giavazzi and Pagano (1988).
115ee Rogoff (1985a) and Fischer (1990).
FEDERAL RESERVE BANK OF ST. LOUIS
125
a contingent rule, or one with escape clauses
that allow member countries to suspend parity
(convertibility) temporarily, may be optimal.12
The rule constrains the government to adhere to
the fixed exchange i-ate except in the case of a wellunderstood
emergency, ~~‘lienit can suspend
pal-it)’ (convertibility under the gold standard)
and issue fiat money. Once the emergency has
passed, with allowance for a suitable delay, the
authority is expected to return to the rule—that
is, to the fixed rate at the original parity. If the
putilic believes in the government’s commitment
to return to the rtile, the government will be able
to raise more revenue than it could with no credibility.
‘the inflation rate during the emergency
would he higher than undet- the rule (when presumably
it would he zero) hut tess than in the
case of put-c discretion. The pattern of alternatbig
fixed and floating exchange rate regimes
over the past 200 years may he well explained
by adherence to a rule with an escape clause. 13
On the other hand, in a regime of floating
exchange rates the inflationary bias of discretionai-
y policy may he overcome by instituting
ct-edible monetary rules or other conimitment
mechanisms, such as an independent conservative
central hank.’~Such mechanisms may Prevent
the perceived disad~-antageof sacrificing
national sovereignty to the supernational (lictates
of a fixed exchange rate.
A fourth issue is that of international coopet-anon
and policy coordination. Recent game theory
literature has demonstrated that coordination of