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Chapter 10 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Chapter 10 Europe’s exchange rate question 2 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition http://nobelprize.org/nobel_prizes/economics/laureates/1999/mundelllecture.html • Robert Mundell – Nobelprize 1999 • "for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas" 3 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The impossible trinity • Monetary union implies a choice between exchange rate stability and monetary policy autonomy • ‘The impossible trinity’, as only 2 of the following can be in place: – Full capital mobility – Autonomous monetary policy – Fixed exchange rates 4 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Unholy Trinity 5 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition What’s On The Menu? Types of exchange rate regimes © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Free floating • The case of the Eurozone, the UK currency, etc • Main Advantages: – autonomous monetary policy making – protection from foreign disturbances • Issue: currency can fluctuate widely and have strong impact on exports 7 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Foreign disturbance and flexible exchange rates Interest rate LM B Foreign rate of return A IS IS’ Output Gap 8 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Other exchange rate regimes • Managed floating: avoiding the ‘fear of floating’ through occasional intervention • Target zones: wide range in which currency is allowed to move vis-à-vis anchor • Crawling pegs: sliding central parity and band of fluctuation • Fixed and adjustable: declared parity vis-à-vis anchor and the realignment option in the face of serious disturbances • Currency boards: fixed exchange rate with monetary policy dedicated entirely to exchange rate target • Dollarization/euroization: adopting a foreign currency with no monetary policy 9 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Hong Kong Currency Boad 10 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Choice of an Exchange Rate Regime • The monetary policy instrument: – can be useful to deal with cyclical disturbances – can be misused (inflation). • The fiscal policy instrument: – can also deal with cycles but is often politicised – can be misused (public debts, political cycles). 11 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The New Debate: The Two-Corners Solution • Only pure floats or hard pegs are robust: – intermediate arrangements (soft pegs) invite government manipulations, over or under valuations and speculative attacks – pure floats remove the exchange rate from the policy domain – hard pegs are unassailable (well, until Argentina’s currency board collapsed…). 12 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Actual Exchange Rate Regimes 13 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The New Debate: The Two-Corners Solution • In line with theory: – soft pegs are half-hearted monetary policy commitments, so they ultimately fail. The World as a Monetary Union •Under metallic money (overlooking the difference between gold and silver) the whole world was really a monetary union. •Previous explicit unions only agreed on the metal content of coins to simplify everyday trading. 14 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Gold Standard and Hume’s Mechanism • Hume’s mechanism implies an automatic change in the money stock to achieve balance of payments equilibrium. Balance of payments = net increase in money supply C 0 A B Gold money 15 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Gold Standard and Hume’s Mechanism: The Trade Account • Money determines the price level (in the long run). Price level Gold money 16 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Gold Standard and Hume’s Mechanism: The Trade Account • The price level affects the trade balance: – if domestic prices are high relative to foreign prices, we have a deficit – conversely, relatively low domestic prices lead to a trade surplus. Price level Trade deficit Trade surplus Gold money 17 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Gold Standard and Hume’s Mechanism: The Trade Account • Trade balance is achieved when the stock of money is M1. Price level P1 M1 Current account deficit Current account surplus Gold money 18 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Gold Standard and Hume’s Mechanism: The Trade Account • Hume’s mechanism: return to balance is automatic: – if we start with deficit (point A, high money stock M0), money flows out until we get back to balance (M1). Price level A P1 Current account deficit Current account surplus M1 M0 Gold money 19 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Gold Standard and Hume’s Mechanism: The Trade Account • Much the same story applies to the financial account: if the domestic interest rate is high (low), capital flows in (out) and the return to balance is automatic. Interest rate A i* 0 M0 M2 Financial account surplus Financial account deficit Gold money • The balance payments adds the current and financial accounts. 20 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Interwar Period: The Worst Of All Worlds • Paper money starts circulating widely. • Yet the authorities attempt to carry on with the gold standard but: – no agreement on how to set exchange rates between paper monies – an imbalanced starting point with war legacies • high inflation • high public debts. 21 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Interwar Period: Three Case Studies • The UK: a refusal to devalue an overvalued currency breeds economic decline. • France: devaluation, under-valuation and beggar-thy-neighbour policies, until others retaliate and the currency becomes overvalued. • Germany: hyperinflation, devaluation and, finally, evading the choice of an appropriate exchange rate by resorting to everwidening non-market controls. 22 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Lessons Learnt • No agreement leads to misalignments, competitive devaluations and trade wars. • Management of exchange rates can’t be left at each country’s discretion: a ‘system’ is required 23 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition European Postwar Arrangements • An overriding desire for exchange rate stability: – initially provided by the Bretton Woods system – the US dollar as anchor and the IMF as conductor. • Once Bretton Woods collapsed, the Europeans were left on their own: – the timid Snake arrangement – the European Monetary System – the Monetary Union. 24 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Bretton Woods System Collapse • Initial divergence. © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition NOK/USD 9,00 8,50 8,00 7,50 7,00 6,50 6,00 5,50 5,00 4,50 4,00 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 2-26 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The European Monetary System: ERM and EMU • ERM – a system of jointly managed fixed and adjustable exchange rates + mutual support: – Fluctuations between +/-2.25% and +/-15% • German Mark as initial anchor • Currently: the ERM 2 system, as entry point into the monetary union • EMU since 1999 and currently with 16 members 27 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition € members 2011 http://www.ecb.int/euro/intro/html/map.en.html 28 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition