From Inflation Targeting to the Euro-Peg: A Model of Monetary Convergence for Transition Economies

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Peer-Reviewed Article

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This study proposes a sequence of monetary convergence to the eurozone, based on autonomous monetary policy rather than on an early application of the euro-peg. The gradual adjustment process begins with a relatively strict variant of inflation targeting, followed by flexible inflation targeting, and ends with exchange rate targeting. A model outlining the optimal mode of policy adjustment is presented. The analysis warns against a premature peg to the euro, which may instigate real currency appreciation, large capital inflows and their costly sterilization. The euro-peg can be introduced only when the candidates’ monetary authorities reach a certain degree of “foundational credibility”. The model of monetary convergence is followed by the empirical assessment of inflation targeting in the Czech Republic and Poland.