Using a panel data approach and three different credibility measures,
we argue that unemployment, inflation, and budget deficits in particip
ating countries have affected the credibility of the Exchange Rate Mec
hanism of the EMS. In contrast to most previous research, which focuse
s upon the credibility of exchange rate policies of individual member
stares, the analysis focuses upon the credibility of the system. The c
redibility indicators used are short-and long-term interest differenti
als vis-at-vis Germany and short-term interest differentials which hav
e been adjusted for expected exchange rate movements within the band.
Both long-term and error-correction models are estimated.