Monetary policy on the road to EMU: The dominance of external constraints on domestic objectives

We estimate forward-looking interest-rate reaction functions for some EMS countries. We model inflation expectations assuming imperfect information and learning. Reputational factors – the shift to a fiscal dominance regime – and convergence to the German inflation rate are found to be the main policy goals. We cannot detect evidence that the target zone band was exploited to implement countercyclical policies: Krugman’s honeymoon effect never materialized for these countries. Thus, their enthusiastic joining of EMU is not particularly surprising. On one hand, the risk of fiscal instability seems definitely staved off. On the other, compared to what de facto happened under Bundesbank leadership during the EMS years, ECB policies are more likely to take into account their relative contribution to the European cycle.