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CHAPTER 14
Policy Coordination, Monetary Union,
and Target Zones
CHAPTER OVERVIEW
Chapter 14 uses the IS-LM-BP and AS-AD models that were developed in chapters 10 through 13 to study the
potential incentives and potential drawbacks of international policy coordination. Specifically, the chapter uses
“beggar-thy-neighbor” negative policy externalities to motivate an incentive for coordinating monetary and
fiscal policies, depending on the nature of the exchange rate regime. The primary potential drawback is a loss of
national sovereignty in setting policy objectives. The chapter also discusses another interesting potential
drawback: When credibility is low for discretionary policymakers, the inflation bias for any one country’s
policymakers can be exacerbated in situations where countries are forced to coordinate their monetary policies.
In addition to monetary and fiscal policy coordination, the chapter also discusses the pros and cons of monetary
union as it is understood from the theory of optimal currency unions. Traditional arguments are first presented
based on the assumption that capital is mobile across regions while labor is not, and is subject to sticky nominal
wages. In this case, region specific changes shifts in aggregate demand or supply will lead to labor market
adjustment in the case of fixed exchange rates or a single currency, which may result in temporary
unemployment. By contrast, under separate currencies, readjustment toward equilibrium can occur via a change
in the exchange rate, thereby reducing the need for labor market adjustment. In this context, an optimal currency
area is defined as a geographical area within which fixed exchange rates may be maintained without slowing
regional adjustments to changing regional circumstances.
The chapter ends with a discussion of exchange rate target zone systems. It is argued that these represent a
compromise between fixed and floating exchange rates, and consequently an alternative to strict monetary
union, in that they can limit exchange rate volatility while still permitting some variation in countries’ currency
values. The S-curve model of exchange rate targeting is presented, and then critiqued. Specifically, the text
points out that recent studies have shown that the empirical evidence does not support the idea that real world
target zones behave as the pure S-curve model predicts. On the other hand, the text notes that these models may
still be relevant once they are extended to account for two important real world facts: (1) Policymakers that
target exchange rates do not typically have complete credibility, and (2) exchange rate interventions typically
occur intramarginally before the rate actually hits either the upper or lower target band.
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OUTLINE
I.
International Interdependence
A. Structural Interdependence and Externalities
B. Policy Cooperation and Coordination
II. International Policy Coordination and Perfect Capital Mobility
A. Aggregate Demand Effects of Monetary Policies
B. Conflicting Monetary Policies and Role of Policy Coordination
C. Potential Gain from Coordination
III. Pros and Cons of International Policy Coordination
A. Potential Benefits
1. Internalizing Policy Externalities
2. Getting Most From Policy Instruments
3. Support From Abroad
B. Potential Drawbacks
1. Autonomy Sacrifice
2. Trust
3. Other Nation’s Qualifications
4. Counterproductive Coordination
5. Monetary Policy With and Without Coordination
IV. Monetary Unions
A. Optimal Currency Areas
B. Shifts in Relative Demands
1. Advantages of Separate Currencies and Floating Rates
2. Advantages of A Single Currency
C. Rationales for Separate Currencies
1. Lack of Fiscal Integration
2. Removal of Currency Competition
3. Europe as an Optimal Currency Area
V. Exchange Rate Target Zones
A. Definition
B. Behavior of Exchange Rate in Zone
C. Target Zone and Facts
VI. Summary
FUNDAMENTAL ISSUES
1.
What is structural interdependence, and how can it lead nations to cooperate or to coordinate their policies?
2.
What are the potential benefits of international policy coordination?
3.
What are the potential drawbacks of international policy coordination?
4.
Could nations gain from adopting a common currency?
5.
What is an exchange rate target zone?
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CHAPTER FEATURES
1.
Management Notebook: “Will the Euro Become the Favored Currency of Organized Crime?”
This notebook discusses large denomination bills issued as currency. It notes that organized crime has
historically favored using $100 bills for many illegal activities, such as money laundering. Interestingly, the
Euro may soon hold the somewhat infamous position because of its larger denomination bills.
For Critical Analysis: The criminal element may be weary of using the large denomination euro notes if the use
of these large denomination notes becomes too closely associated with illegal activities.
2.
Policy Notebook: “The ECB’s Odd Voting Arrangement”
This notebook examines the set-up of the ECB. It discusses the link between the ECB and the individual
national central banks, which are expected to carry out the policies prescribed by the ECB. Further, it discusses
the setup of the ECB which is designed to be free of political interference. It is noted, however, that due to lack
of accountability, the ECB may find it difficult to obtain public support for its actions. Finally, the weighting of
votes among ECB countries seems to be disproportionately favoring smaller countries, as illustrated in Table
14-1.
For Critical Analysis: The small country bias may affect policy making decisions if the small countries
coordinate their desired policy goals and votes if and when they conflict with acknowledged policy goals of the
larger, more established ECB member countries.
ANSWERS TO END OF CHAPTER QUESTIONS
1.
This would be a situation of policy coordination, because the nations would actively be working together to
establish a common payment mechanism and regulatory framework that would apply simultaneously to
both countries’ banking systems.
2.
This is an example of a negative policy externality because the domestic tax cut tends to stimulate domestic
real-income growth at the expense of lower real-income growth in the other country. As a result, the
domestic tax cut has a beggar-thy-neighbor effect on the other nation.
3.
According to the optimal-currency-area theory, these three economies are good candidates for a single
currency. If events were to affect the sub-regions differently, causing payment imbalances among the subregions, then the residents, who share a common culture and language and are highly mobile, could adjust
by moving as desired among the regions. Hence, exchange-rate adjustments are not necessary to cushion
the sub-regions in the face of such imbalances. Adopting a single currency would permit them to avoid the
sizable currency-conversion costs that they currently face.
4.
One economic argument they might give relates to the standard case for a fixed exchange rate: It saves
households and firms the costs of hedging against risks of exchange-rate fluctuation, which definitely
cannot occur under a common currency. Indeed, with a common currency there also is no risk of currency
realignments that can take place under fixed exchange rates among multiple currencies. Another argument
is that adopting a common currency provides a basis for lower European-wide inflation if the European
Central Bank achieves greater monetary policy credibility relative to the current central banking institutions
of Europe. Finally, moving to a common monetary policy might help engender greater coordination of
fiscal, banking, and trade policies among the participating nations.
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5.
The language barrier combines with the other legal and natural barriers for factor movement and serves as
an impediment to labor mobility. In this case, the country could benefit from adopting a flexible exchange
rate. If a flexible exchange rate were in effect, the increased trade deficit would lead to a natural
depreciation of the nation’s currency. This would help to stabilize aggregate demand (i.e., reduce its fall)
by making imports more expensive and exports less expensive. Maintaining a fixed exchange rate
eliminates this stabilizing channel.
6.
The single currency in Europe would work even better in Europe if there existed a single common language
because the common language would make it easier for labor to be mobile; a key assumption to the theory
behind an optimal currency area.
7.
Potential benefits of national coordination of monetary policies include the internalization of policy
externalities, the optimization of the outcome of the limited set of policy instruments, the benefit of
external commitments when faced with internal pressures to follow short-term goals at the expense of long
term stability. Answers will vary as to which one is considered the most important.
8.
Potential disadvantages of monetary policy coordination include the sovereignty an individual country
sacrifices, the potential of one country to “cheat” on another by deviating from the agreed upon
coordination strategy, the potential of poor policy making by a member country, and the added potential of
inflation bias when credibility levels are low within individual nations. Answers will vary regarding which
is the greatest sacrifice.
9.
In light of these tradeoffs, countries may agree to only intermittently coordinate policies when the countries
involved are similarly affected by an exogenous shock (e.g., an energy price increase). In such a situation,
the countries are recovering from a common shock, and share similar policy goals. Thus, they can make the
most of the advantages of policy coordination while at the same time minimizing the disadvantages of
policy coordination.
MULTIPLE CHOICE EXAM QUESTIONS
1.
Structural interdependence is defined as the
A. relationship between fiscal and monetary policies when the central bank is not fully independent.
B. ink between a short-term increase in cyclical unemployment and a gradual increase in structural
unemployment.
C. relationship between a country’s wage-setting institutional structure and the slope of the aggregate
supply schedule.
D. interconnectedness of countries’ market, which causes events in one nation to affect the economy of
another nation.
Answer: D
2.
Which of the following is an example of an international policy externality?
A.
B
C.
D.
the locomotive effect
the balance-of-payments schedule
sterilization
central bank independence
Answer: A
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The Group of Seven is a group of countries that have agreed to engage in
A.
B.
C.
D.
international policy cooperation.
a monetary union.
a fixed exchange rate regime.
a shared independent central bank.
Answer: A
4.
The Basle agreement, which established common risk-based capital adequacy standards for private
banking institutions, is an example of
A.
B.
C.
D.
central bank independence.
international policy coordination.
high capital mobility.
a monetary policy rule.
Answer: B
5.
In a two-country model with perfect capital mobility and a floating exchange rate, an increase in the
domestic stock of money
A.
B.
C.
D.
creates a positive policy externality for the foreign country.
induces a decrease in foreign income.
induces no change in foreign income.
induces an increase in foreign income.
Answer: B
6.
In a two-country model with perfect capital mobility and a floating exchange rate, a decrease in the foreign
money stock leads to a
A. capital inflow into the domestic economy, an appreciation of the domestic exchange rate, and a
reduction in domestic aggregate demand.
B. capital inflow into the domestic economy, a depreciation of the domestic exchange rate, and a
reduction in domestic aggregate demand.
C. capital outflow from the domestic economy, an appreciation of the domestic exchange rate, and an
increase in aggregate demand.
D. capital outflow from the domestic economy, a depreciation of the domestic exchange rate, and an
increase in domestic aggregate demand.
Answer: D
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7.
In the two-country model with perfect capital mobility and a floating exchange rate, each central bank has
an incentive to raise the stock of money, raising output in the domestic economy at the expense of the
foreign economy. This is an example of
A.
B.
C.
D.
international policy coordination.
international policy cooperation.
a conflict in monetary policymaking.
an optimal currency area.
Answer: C
8.
Which of these is not a benefit of international policy coordination?
A.
B.
C.
D.
internalizing international policy externalities
gaining support from abroad domestic policy actions
achieving multiple objectives with a limited number of policy instruments
reducing national sovereignty
Answer: D
9.
Kenneth Rogoff suggests a way in which “successful” monetary policy coordination may reduce joint
economic welfare. In this model, the reduction in welfare occurs because
A.
B.
C.
D.
the commitment to maintain the exchange rate is not credible.
coordination increases capital mobility.
coordination produces a larger inflation bias in each economy.
the coordination effort necessitates offsetting contractionary fiscal policy.
Answer: C
10. A monetary union is
A. a geographic region in which labor is sufficiently mobile so as to offset asymmetric shocks to
aggregate demand.
B. a set of countries that choose to use a common currency.
C. a range of exchange rates in which the central bank allows the nominal value of the currency to float.
D. an informal international agreement to fix nominal exchange rates.
Answer: A
11. An optimal currency area is
A. a range of exchange rates within which the central bank allows the exchange rate to float, while at the
same time preventing the exchange rate from moving outside that range.
B. the quantity of the nominal stock of money that is consistent with the highest level of domestic
welfare.
C. a geographic region in which there are no barriers to trade between countries in the region.
D. a geographic region in which welfare is greater when the respective governments fix the exchange rate
or adopt a common currency.
Answer: D
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12. The primary benefit of separate currencies and a floating exchange rate, relative to a monetary union, is that
A.
B.
C.
D.
there are lower transactions costs in international trade.
real wages can adjust more quickly to demand shocks.
firms need not hedge the risks associated with currency movements.
monetary policy coordination is easier.
Answer: B
13. Under a monetary union, adjustment to relative price shocks between regions takes place through
A.
B.
C.
D.
coordinated monetary policy.
nominal exchange rate movements.
the migration of labor between regions of the union.
nonsterilized monetary expansion in the region that experienced the negative demand shock.
Answer: C
14. Which of the following is an advantage of a monetary union, as compared to separate, floating currencies?
A. currency competition
B. domestic control of seignorage revenues
C. relative price movements between regions that allow the real wage to adjust, even when the nominal
wage is sticky
D. lower transaction costs in international trade
Answer: D
15. Arguments against a European monetary union include all of the following except that
A.
B.
C.
D.
it would reduce currency conversion costs.
some nations have specific sentimental or historical ties to their respective currencies.
labor mobility within Europe is too low to be consistent with such a union.
it limits the fiscal autonomy of national governments.
Answer: A
16. The budgetary criteria for admission to the European Monetary Union require each entrant to have
A.
B.
C.
D.
a balanced budget and low inflation.
an independent central bank.
government debt of less than 60% of GDP and a government budget deficit of less than 3% of GDP.
a per capita GDP of at least $20,000.
Answer: C
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17. As of 1998, which of the following countries fully meets the Maastricht criteria on budget deficits and total
government debt?
A.
B.
C.
D.
Luxembourg
Belgium
Italy
Greece
Answer: A
18. Asymmetric shocks are
A.
B.
C.
D.
incentives that lead central banks to “cheat” on their international commitments.
a measure of the ease with which labor moves between regions.
an example of international policy coordination.
variations in aggregate conditions that have different effects on separate geographical regions.
Answer: D
19. Labor mobility is important to a monetary union because
A. the central bank in a monetary union cannot alter the stock of money.
B. inflation is necessarily higher in a monetary union.
C. asymmetric shocks induce real wage differentials that may not be offset by changes in a nominal
exchange rate.
D. the slope of the aggregate supply curve does not depend on contract lengths in monetary unions.
Answer: C
20. Compared to the United States, the European Union has ________ economic divergence and ________
labor mobility.
A.
B.
C.
D.
higher; lower
lower; lower
higher; higher
lower; higher
Answer: A
21. While the European Union may not represent an optimal currency area, economists have identified a subset
of economies known as the European core. The European core would appear to be good candidate for a
monetary union because
A. economic divergence between regions within the core is low, and labor mobility between these regions
is high.
B. these countries have had broadly similar fiscal policies over the last decade.
C. these countries all currently meet the budgetary criteria that appear in the Maastricht treaty.
D. none of the European core countries has any special historical or cultural attachments to their
respective currencies.
Answer: A
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22. An exchange rate target zone
A. suffers from none of the credibility problems associated with a fixed exchange rate.
B. is the geographic area within which labor mobility is sufficient to justify the use of a common
currency.
C. is a range of permitted exchange rate variation between two exchange rate bands that the central bank
defends by intervening in the foreign exchange market.
D. is another term for a policy of fixed exchange rates.
Answer: C
23. Which of the following exchange rate regimes provides the greatest ability to pursue a monetary policy that
is independent of the actions of monetary authorities in the rest of the world?
A.
B.
C.
D.
target zones
floating exchange rates
fixed exchange rates
monetary union
Answer: B
24. Within an exchange rate target zone, the movement of the exchange rate in response to the monetary
growth rate takes the form of
A.
B.
C.
D.
a straight line.
a parabolic function.
an S-shape curve.
Monetary growth does not affect the exchange rate in an exchange rate target zone.
Answer: C
25. In a target exchange rate zone, movements in the nominal exchange rate are affected by expectations
among foreign exchange traders. These expectations lead the exchange rate to
A. be more responsive to monetary growth rates than it would be under a pure floating exchange rate
system.
B. be less responsive to monetary growth rates than it would be under a pure floating exchange rate
system.
C. be unaffected by changes in monetary growth rates.
D. increase one-for-one with changes in monetary growth rates.
Answer: B
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26. Which of the following is a possible reason that exchange rate movements within target zones do not
appear to follow the hypothesized S-shaped curve?
A.
B.
C.
D.
Perfect capital mobility.
Imperfect policy credibility.
The presence of asymmetric shocks.
Immobile labor.
Answer: B
27. Intra-marginal interventions
A.
B.
C.
D.
are most common in fixed exchange rate regimes.
are a form of fiscal stabilization.
occur only when the exchange rate reaches its target level.
are attempts by the central bank to affect exchange rate movements within the target zone.
Answer: D