The monetary linkages between Italy and the EMS

Madonia, Giuseppina (1991) The monetary linkages between Italy and the EMS. University of Southampton, Doctoral Thesis.

Abstract

The aim of this research is to investigate some of the issues related to the analysis of monetary policy in a small open economy which is a full member of the EMS. We examine in detail how different aspects of the ERM of the EMS affect the modus operandi of member countries' monetary policy, focussing on Italian monetary policy, and go on to develop some of these issues. In particular, we describe the history of capital controls and their removal in Italy, and the ways in which they have affected monetary policy. We go on to model the links an ERM member has both with other EMS countries and with the rest of the world. To do this we develop a three-country open economy model within a `modified' monetary approach. The exchange rate regime considered is a mixed one: a floating rate between the United States and West Germany (and Italy) and a fixed rate between West Germany and Italy. The model is used to examine analytically the impact of monetary and fiscal policy in the three countries on the equilibrium world interest rate, the dollar-deutschmark (and dollar-lira) rate and foreign reserves held by the Bank of Italy (and the Bundesbank). We also determine the impact effect of a devaluation/upward revaluation in the deutschmark-lira rate on the same endogenous variables. The model results show that the predictions of traditional two-country open economy models, for example, the Mundell-Fleming model, are maintained in a framework which allows for both floating and fixed exchange rates. However, the analytical exercise enables us to identify the conditions under which some of the results occur. We also derive and test for Italy, West Germany, the United Kingdom and the United States (over the floating and EMS periods) an alternative approach to the analysis of sterilisation policies. The empirical results suggest that two different models are appropriate for Italy and West Germany but for the United Kingdom and the United States none of the estimated models are accepted.

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