SIMPLE TESTS OF TARGET ZONES - THE IRISH CASE

In a small open economy with fixed exchange rates, standard theory sug gests that domestic inflation and interest rates should equal those ab road. In a credible target zone, the same theories suggest that inflat ion and interest rates should be 'close'. Here, we seek to make precis e this idea of limits on inflation and interest rate differentials con sistent with limits on exchange rate movements. We then examine the ca se of Ireland, which joined the Exchange Rate Mechanism (ERM) of the E uropean Monetary System (EMS) in 1979 attracted by the prospects of lo wer, German influenced, inflation and interest rates. We find in the e arly years of the ERM, both Irish inflation and interest rates were in consistent with credibility of the exchange rate regime; in the latter years, from 1987 on, rates were in the derived range around German ra tes.