Journal of International .Cfone.v and Finance (1990). 9, 358-375 German dominance in the EMS: evidence from interest rates JURGEN VON HAGEN zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONML AND MICHELE FRATIANNI* Graduate School of Business, Indiana University, Bloomington, Indiana 47405, USA The paper presents an empirical analysis of German dominance and asymmetries in the EMS based on a dynamic system of equations explaining national money market interest rates. The hypothesis of strict German dominance of the EMS is rejected. However, there are some noticeable asymmetries in the EMS. Germany is a relatively strong player and has been the least dependent country in the early phase of the system. Since 1983, German independence has diminished. In contrast, France throughout and Italy in the early phase of the EMS have been relatively weak players in the system. When the European Monetary System (EMS) was founded in 1978 among Belgium, Luxemburg, Denmark, France, Germany, Ireland, Italy, the Netherlands, and the UK, its creators envisioned a new kind of exchange rate arrangement, flexible enough to support different inflation trends for the member countries, and symmetric enough to make all members share in the burden of adjustment to eliminate balance of payments disequilibria.’ Based on the principles of symmetry and flexibility, the EMS would leave each member the freedom to choose its own, most preferred inflation rate. Today, the prevailing view of the EMS among economists and policymakers rejects this vision. In sharp contrast to the original intentions, the EMS is generally regarded as an asymmetric system, which is dominated by the German Bundesbank. We will call this view the German Dominance Hypothesis, GDH. GDH claims that the EMS is a coercive arrangement forcing the other members to follow the disciplinary, low-inflation policy rule of the Bundesbank. EMS membership has meant for these countries to surrender (part of) their monetary policy autonomy to the leadership of the Bundesbank. For example, Katseli (1987) argues that ‘within Europe, domestic central banks have chosen to lose some of the “economic effectiveness” of domestic monetary policy and accept the leadership of the Bundesbank.. ..’ Fisher (1987, p. 41) describes the EMS as ‘an arrangement by France and Italy to accept German leadership, imposing constraints on their domestic monetary and fiscal policies.’ * Respectively, Assistant Professor and Professor of Business Economics and Public Policy. This paper was written while Jiirgen van Hagen was a Visiting Scholar at the Federal Reserve Bank ofSt. Louis. Helpful comments from two referees are gratefully acknowledged. 0261-5606/90,‘04/0358-18 6 1990 Butterworth-Heinemann Ltd