First, the inability to enforce commitment, because monetary arrangements can always be changed in the absence of an outside enforcer, means that no such  3  Torsten Persson and Guido Tabellini (1999) argue that if it takes sufficient time for a government to tear up contracts designed to eliminate the inflation bias (longer than the duration of nominal contracts) promises not to inflate can be credible. 4  Svensson (2002) takes the same view of McCallum (1995) in his comments on Stokey (2002), thus: “…to my knowledge neither McCallum nor anyone else has presented a model where ‘just do it’ is an equilibrium outcome.”[p4]. 5  “The institutional structure of monetary union forms the basis for public trust in the euro and rests on two pillars: the stabilityoriented monetary constitution enshrined in the Maastricht treaty, and the stability and growth pact. Both pillars are being undermined, leaving European monetary union in a very grave predicament”. (Ernst Welteke, The Times, 4 December 2003). 6  Daron Acemoglu (2003) argues that inefficient policies can occur in a democracy because those in political power cannot commit to maintaining the policies that are required to achieve efficient outcomes. In other words, the Coase theorem does not apply at the level of society as a whole. BIS Review 5/2004  3  arrangement is sacrosanct for all time.
BIS Review 5/2004  5  while the peg was being defended, they were soon lowered to more sustainable levels. The expectations that had been built into forward exchange rates were proved correct. Chart 1: Exchange rates and monetary policy in Brazil, Jan 1998-Dec 1999 50  $  Per cent  0  45 40 35  0.5 Spot exchange rate (rhs)  Overnight interest rate (lhs)  30 25  1 1.5  20 15 10 5  Implied forward exchange rate (rhs)  0 Jan-98 May-98 Sep-98  2 2.5 3  Jan-99 May-99 Sep-99  Source: JP Morgan and Banco Central do Brasil  In the literature on target zones for exchange rates, it is assumed that raising interest rates is a successful method for supporting the exchange rate because of uncovered interest parity. But this ignores the possibility that raising interest rates to defend a fixed exchange-rate regime will simply call into question the durability of the regime itself and raise the probability that the peg or target zone will be abandoned. In such circumstances an increase in interest rates may lead to a fall in the exchange rate. A second example of the same phenomenon is the pressure on sterling during 1992 and its forced departure from the Exchange Rate Mechanism on 16 September of that year.