THE INTERNATIONAL CONVERGENCE OF INFLATION RATES DURING FIXED AND FLOATING EXCHANGE-RATE REGIMES

According to the assets approach to the balance of payments/exchange r ate, under a fixed exchange rate regime, inflation must grow at the sa me rate in each of the participating countries, at least in the long r un. The model implies that reserve currency inflation causes world inf lation. The mechanism by which inflation is transmitted when currencie s are allowed to float is more complex. The long run international con vergence of inflation is studied using modern time series techniques o n post-war data from the G-7 countries. The evidence on the convergenc e of inflation during the fixed regime portion of the sample is strong and consistent with the notion of reserve currency causality, i.e. fr om the US to the rest of the world. The evidence of convergence over t he floating portion of the sample is also quite strong, but no single currency can be characterized as the common underlying source of world inflation implying the inflation rates are endogenous. (JEL C32, E31) . Copyright (C) 1996 Elsevier Science Ltd