Exchange Rate Policy and Disinflation: The Spanish Experience in the ERM

PAIN is certainly one of the Western European countries that has experienced the most dramatic changes in the past 20 years. In addition to a political shift from dictatorship to democracy in the mid-1970s, the economic structure has been deeply reformed. These changes, including the process of European integration, have been generally beneficial to the nation. However, they have also posed important policy challenges. This has been particularly the case for monetary policy. The Spanish central bank, the Banco de Espana, has been concerned with two major objectives associated with European monetary integration. The first and most important goal is nominal convergence, i.e. a reduction of inflation to reach German standards. The second objective is exchange rate stabilisation with respect to other currencies in the European Union (EU). The challenge has been to reconcile these aims with a rapidly changing economy affected in particular by trade, financial and capital account liberalisations. A specific problem has been the presence of significant capital inflows in the late 1980s. These inflows were caused by two main factors: first, the various reforms and especially EU membership in 1986; second, a tight monetary policy with high interest rates. Overall, the monetary policy challenge has been met only with mixed results. A strategy of exchange rate stabilisation was followed between 1987 and 1992, including membership in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) after June 1989. This strategy appeared successful in the