Has the EMS reduced member-country exchange rate volatility?

Using tests for unit roots, serial correlation, and conditional heteroskedasticity, we find that the stochastic structure of the percentage changes in both the Franc/DM and Lira/DM rates is well described by a low order autoregression with ARCH disturbances. While this assertion is not rejected in either the Pre-EMS or the EMS period, we present evidence indicating a structural shift between sub-periods. In particular, while ARCH is present in each sub-period, its explicit parameterization changes dramatically.Likelihood-ratio tests indicate the desirability of a bivariate analysis, and significant ARCH effects are found in the conditional variances and covariances over both subperiods. Likelihood ratio tests also indicate substantial structural change between the subperiods. The conditional variances of exchange rate innovations are used as natural measures of exchange rate volatility; it is found that volatility decreases substantially for both rates in the EMS period. Furthermore, the Franc shows a relatively greater volatility decrease with the move to the EMS, a result consistent with the narrower parity bands established for the Franc. Finally, the covariation of shocks to the two intra-EMS rates is shown to decrease between the Pre-EMS and EMS periods.