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International Finance
Part 1
Fundamentals of
International Finance
Lecture n° 3
A case for monetary integration,
and the European Union
1
Exchange rate management
Introduction
Goals of the chapter :
Ask whether a flexible exchange rate system is desirable,
Discuss the argument for greater exchange rate fixity
Flexible exchange rate system
Implies a minimum of insitutional design
Carry weaknesses linked to this minimal framework :
• Uncertainty
• Lack of discipline
• Problems of volatility and misalignments
Case for more managed exchange rates
Then leads to problems of speculative attacks if monetary
policy is inconsistent with fixed exchange rate target. 2
Exchange rate management
The case for flexible exchange rates - Arguments
Defined as
« Rates of foreign exchange that are determined daily in
the markets for foreign exchange by forces of demand
and supply… »
Avoid the intervention of the government and the possible
run out of reserves
Automatically adjusts the BOP disequilibria
Speculators facilitate and smooth the adjustment of the
exchange rate, having a stabilising effect
Confer monetary autonomy to a country
Provide insulation from external shocks via exchange rates
adjustements, upward or downward.
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Exchange rate management
The case for flexible exchange rates - Challenges
However, the argument for flexible exchange rates
have been seriously challenged to several extents.
Floating rates since 1973 have exhibited high volatility and
spent long periods away from their long-run fundamental
equilibrium level (misalignement)
Domestic price of
foreign exchange
Supply of foreign
exchange
Seq
Demand for
foreign exchange
Q of foreign exchange 4
Exchange rate management
The case for flexible exchange rates - Challenges
Exchange rate determination models do not seem to prove
empirically that fundamentals drive the exchange rate.
Studies showed that same current account imbalances
persisted after the adoption of floating exchange rates in
1970 ’s and 1980 ’s.
Changes in prices caused by depreciation may not alter
demand for the product (ex. Switzerland, Germany, Japan),
in particular for high quality goods with few substitutes.
Monetary autonomy ? UK example in 1979-1981 where
monetary tightness rise interest rates, causing a huge
capital inflow, leading to exchange rate appreciation,
affecting badly the tradeable sectors.-> few autonomy.
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Exchange rate management
The case for flexible exchange rates - Challenges
Insulation from external shocks?
Full insulation : idea abandoned.
Still a question on whether flexible rates better insulate
the domestic economy. Via, p.ex., appreciation of the rate
in case of rise of foreign demand for domestic exports,
and vice versa.
Empirical results are mixed.
Overall : several exaggerated benefits for flexible
exchange rates.
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Exchange rate management
The benefits of greater exchange rate fixity
Four arguments in favour of some degree of exchange
rate intervention :
The discipline argument : helps to promote lower
inflation.
The need to reduce exchange rate volatility : more
uncertainty can reduce the volume of trade.
The desire to eliminate misalignments : long period of
over- and undervaluation - like displayed in the floating
rates period - results in various cost for the real sector.
The benefits of a single currency
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Exchange rate management
Exchange rate fixity : The Discipline argument
(1) Flexible rates tend to promote inflation (evidence is
mixed and theoretically unlikely)
(2) Fixed exchange rate force countries to contain
inflation : one of the core arguments in favour of EMS.
Consider 2 countries :
• UK : high inflation, and current account deficit
• Germany : low inflation, and current account surplus
• In theory : leads to a tendency of appreciation of the DM :
Bundesbank should sell DM against foreign currencies,
expanding the monetary base, and reducing pressure on S.
• UK : should disinflate, buy Pounds against foreign currencies
to reduce pressure of depreciation.
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Exchange rate management
The Discipline argument
Asymmetry : Germany could sterilise (and avoid a price
rise) by selling bonds against DM, reducing back the
monetary base. UK cannot sterilise much, soon running out
of reserves. -> this asymmetry leads to a disinflationary
bias.
And, the credibility bonus brought by the exchange rate
target reduces the costs of disinflation in terms of
unemployment : agents easily observe the exchange rate
target and believe that inflation will fall -> they adapt their
wage bargaining behaviour.
Exchange rate targets are more efficient (credible)
disinflation tools than monetary growth targets.
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Exchange rate management
Exchange rate fixity : The Volatility argument
Need to reduce exchange rate volatility : more
uncertainty can reduce the volume of trade.
Foreign direct and long-run foreign investment might
also decline in greater exchange rate uncertainty.
Sudden changes in the value of reserve currencies can
be problematic.
However, possible recourse to the forward market, but:
only existing for large currencies,
can be expensive.
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Exchange rate management
Exchange rate fixity : The Misalignment argument
Floating rates have a tendency for persistent departures
from long-run equilibrium
Long period of overvaluation and undervaluation cause
changes in the price of tradeables goods relative to non
tradeables.
• Example : persistent overvaluation, causing industries to become
uncompetitive, but capital and labour are not easily convertible
into other, non tradeable sectors
• -> overvaluation usually leads to unemployment and
underutilisation of resources, and ultimately, to
desindustrialisation.
Also : effect of misalignment on long-term debt accumulated
in foreign currencies : can significantly change the return of
project financed by borrowed currencies.
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Exchange rate management
Exchange rate fixity : The Single Currency
Benefits of a single currency within any country are :
simplification of the profit-maximising computations of
producers and traders
facilitated competition among competitors of the country
promotion of the integration of the economy into a
connected series of markets for the factors of production
If single currency among different countries : accrued
benefits due to the suppression of the transaction costs of
exchanging currencies.
If exchange rate management : part of these listed benefits
could be achieved, compared to a fixed rate regime.
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Single Currency
Costs of a single currency
Costs : of a single currency across different countries:
loss of the exchange rate
loss of the monetary policy
Loss of exchange rate :
Eliminate the possibility of using the exchange rate as a
policy instrument to rectify external equilibria.
• Example : External shock of price fall in steel leads Belgium
(large exporter) to a deficit on its current account.
• Belgium should either deflate (allowing prices to fall) or let the
currency depreciate (or devalue if fixed exchange rate) in
order to restore equilibrium.
• If prices are sticky and cannot fall to restore competitiveness,
deflation (i rises, M falls) will create unemployement.
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Single Currency
Costs of a single currency - loss of exchange rate
Example :
If Belgium is in a monetary union : no depreciation is
allowed, the economy will go into recession.
Belgium has no longer a BOP problem, but has a
regional problem within EMU.
Three factors mitigating the costs :
Factor mobility
Openness of the economy
Product diversification
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Single Currency
Costs of a single currency - Mitigation factors
Factor mobility
The greater the mobility of capital and labour, the lower
the cost of joining a monetary union.
Example : asymmetric demand shock : rise of D in region
A, drop in region B. If prices are sticky downwards, region
B will have unemployement, and inflationnary pressures in
region A.
Solution : move unemployed workers from region B to
region A.
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Single Currency
Costs of a single currency - Mitigation factors
Openness of the economy
The loss of exchange is less costly if the economy is more
open.
Reason : exchange rate changes are less effective at
improving competitiveness because money illusion is reduced.
In fixed exchange rates, devaluation increase competitiveness
via the drop real wages following the increase in prices of
imported goods.
In open economies, workers anticipate this change and will
adjust their demand of wage increase to offset the effect.
Product diversity
A demand disturbance in one product is less likely to affect
significantly the exchange rate, if the diversfication is large.
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Single Currency
Costs of a single currency - Loss of monetary policy
Costs : of a single currency across different countries:
loss of the exchange rate
loss of the monetary policy
Loss of monetary policy :
Eliminate the ability to conduct an individual monetary
policy, since monetary policy is directed from the centre
rather than from individual countries.
Many believe that the more similar inflation rates countries
have, the more appropriate candidates they are for a
monetary union.
More generally : the closer degree of policy integration at
macro level, the more easy it is to form a monatery union.
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Single Currency
Criteria for countries to benefit from a single
currency
Similar policy goals
Similar macroeconomic performance
Close inflation rates
Conduction a lot a of trade transactions between one
another.
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European Monetary Union
Introduction
European Union : case study for exchange rate co-operation
leading to a monetary union. Catalogue of lessons about
benefits and costs of a single currency, and of advantages and
disadvantages of different institutional structures.
History:
European Monetary System (EMS) started in 1979 with
relatively flexible target zones, becoming progressively more
rigid.
1987 - 1993 : rigid exchange rate fluctuation bands
1993 : large speculative attacks, causing a large threat on
the system. Introduction of Euro postponed of 2 years.
1999 : Euro as scriptural common currency
2002 : Euro as fiduciary common currency
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European Monetary Union
The European Monetary System (EMS)
Main objective of EMS : promotion of monetary stability
within Europe.
Three immediate aims as established in 1979 :
Reduction of inflation in EU countries
Promotion of exchange rate stability to favor trade flows
and investments
Gradual convergence of economic policy, allowing for
more fixed exchange rates.
Features of the EMS
Three main elements : the European Currency Unit (ECU),
the Exchange Rate Mechanism (ERM) and the European
Monetary Cooperation Fund (EMCF).
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European Monetary Union
The ECU : weighted average of all EU currencies, weights
depending on the size of each country and its importance in
intra-EU trade (DM, FRF, Sterling).
ERM : exchange rates allowed to fluctuate up to 2.25% or
6% on either side of the central rate.
July 1993 : fluctuation bands were extended to 15%.
Currencies maintained within bands through compulsory
interventions by the monetary authorities.
Possibility for the central rate to be realigned (7 until
1987; DM and DG always revalued)
EMCF : provides credit for members to help in adjusting
balance of payments problems, at short-term (9 months) or
medium-term (2-5 years).
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European Monetary Union
The European Monetary System (EMS)
The achievements of the ERM :
Stability of the exchange rates
• The cost of higher interest rates volatility (to reduce
pressure on X rates) has been avoided thanks to the capital
controls in the ERM in the 1980’s.
• Question of the benefits of exchange rates stability on the
intra-EU trade. Khalid & Sapir (1990) find little evidence of
the effect of X rate volatility on prices -> little impact on
commercial trade activities
Reduction of inflation
• Argument : due to asymmetry effect in fixed X rates regime,
deficit countries have to disinflate, whereas surplus
countries could avoid inflationary policies by sterilisation.
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European Monetary Union
Reduction of inflation in EU - empirical evidence
• Number of pieces of evidence which suggests that ERM has
worked asymmetrically.
• Intervention within the system support the view that
Germany was the leader.
• Inflation in initially higher inflation countries did converge on
German levels.
• Idea of a reduced cost of disinflation (in terms of
unemployment), thanks to the credibility bonus brought by
the pegging of currencies to low inflation countries
(Germany).
• However, empirical evidence is mixed on this view. But high
costs in ERM countries might be due to the nature of the
labour markets (half way between high centralisation and
high decentralisation).
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European Monetary Union
The European Monetary System (EMS)
The stability of the ERM : why the ERM has been so
successful during such a long period of time?
Five factors identified in the literature :
(1) Co-operation among ERM countries and the existence
of the various financing facilities.
• ERM is part of a wider, institutionalized, co-operation
framework among European countries : Single Economic
Market (1992), Agricultural policy, … Financing facilities in
provide Central Banks of large amount of money in case of
speculative attacks.
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European Monetary Union
The European Monetary System (EMS)
Five factors of stability for the ERM :
(2) Clever operational features in the design of the
exchange bands :
• Co-existence of narrow bands (2.25%) and wider bands
(6%), providing some flexibility for high inflation countries,
allowing them to gradually adapt their economic policies.
• Wider bands can help realignments : a narrow band country
(e.g. France) can realign (ex : +3.5%) while a wider band
country may avoid realignment (since 3.5%< 6%).
Therefore, speculator can expect the sense of realignment
for France, but face greater uncertainty on the case of Italy
-> reduce the probability of a speculative attack.
• Timing of realignment decided very quickly (until Sept 1992)
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decreased speculative pressures.
European Monetary Union
The European Monetary System (EMS)
Five factors of stability for the ERM :
(3) Luck. Several fortuitous circumstances promoted
stability within ERM.
• Co-operation of policy goals among several ERM
governments, focusing on disinflation and willing to accept
the discipline implied by the system (in the 1980’s).
• UK was not a member : DM was the only large currency in
the system, and policy disagreements - possibly - have been
avoided.
• Strength of the dollar in the 1980’s reduced the pressure for
appreciation on the DM. The dollar’s fall had then been
managed according to the Plaza and Louvre agreements.
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European Monetary Union
The European Monetary System (EMS)
Five factors of stability for the ERM :
(4) Existence of capital controls
• Allow some monetary independence to the countries, by
preventing large capital flows if interest rates differentials.
Ex. tight monetary policy of Spain in the late 1980’s (high
interest rates). Peseta protected from depreciation pressures
thanks to controls on capital inflows.
• Help to prevent speculative attacks, by reducing the amount
of money flowing in or out of a currency. Allowed then to
delay some realignment decisions and anti-inflation policy to
develop (without deprecation as soon a inflation rises).
• Capital controls within ERM slowly eliminated by the end of
the 1980’s.
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European Monetary Union
The European Monetary System (EMS)
Five factors of stability for the ERM :
(5) Growing credibility of the exchange rate parities
• Some authors argue that the system would have been viable
even without capital control, since it was credible, and
realignments were not credible (the 1993 crisis proved the
contrary).
Crises of the ERM - Facts
September 1992 : speculative attacks leading to the
departure of Italy and the UK from the system. Peseta
devalued by 5%. Ireland, Portugal and Spain tightened
their capital controls.
July 1993 : Several realignments of Ireland, Portugal and
Spain. Pressure on the FRF and bands extended to 15%.
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European Monetary Union
Crises of the ERM - Triggering Factors
Breakdown in the economic policy agreement. France
wanted to focus on growth and unemployment, Germany
trying to absorb the shock of the reunification. Recession
on major industrialised countries.
Release of capital controls, according to the Delors plan to
monetary union, implying lesser flexibility on exchange
bands (2.25% for all) and no capital controls.
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European Monetary Union
Economic and Monetary Union - plan
Delors report (1989), basis of the Maastricht Treaty :
Monetary union to be achieved by a gradualist and
parallel approach:
• Parallel : economic convergence to achieve at the same time
as monetary union (the one needing the other)
• Gradualist : economic integration is a slow process
Stage 1 : all countries join ERM with 2.25% fluctuation
bands, capital controls removed, single financial area.
• Stage 1 began on July 1, 1990.
• Maastricht Treaty signed in December 1991, setting a
timetable for the whole process.
• Stage 1 was supposed to be completed by end of 1993, but
the exchange rate crises set back the process.
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European Monetary Union
Delors report (1989), basis of the Maastricht Treaty :
Stage 2 : exchange rate commitment more stringent.
Realignments expected to be more infrequent. Creation of
a central European body in charge of the monetary policy.
• Started in January 1994.
• The European Monetary Institute (EMI) was created to coordinate monetary policy.
Stage 3 : irrevocable fixing of the exchanges rates,
replacement of the national currencies. Monetary policy
fully transferred to the European Central Bank.
• From January 1997.
• Adoption of the Euro of 11 members in January 1999,
Greece joined in 2001.
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European Monetary Union
Delors report (1989), basis of the Maastricht Treaty :
Stage 3 : Convergence criteria
• Inflation max 1.5% above the average of the 3 lowest
inflation countries.
• Interest rates on LT government bonds max 2% above the
average of interest rates in the 3 lowest inflation countries.
• Government deficit does not exceed 3% of the GDP.
• Government debt to GDP ratio does not exceed 60%.
• The exchange rate must have been fixed within its ERM
without a realignment for at least 2 years.
• The statutes of the central banks should be compatible with
those of the ECB.
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European Monetary Union
Costs and Benefits of the EMU
Benefits
The European Commission estimated to gains to 10% of
the EU GNP. Benefits should come from :
suppression of transaction costs (0.5%)
greater monetary stability
elimination of the exchange rate risk
Emerson (1990) : single currency will promote efficiency,
stability, and equity by better and most efficient allocation
of the resources and more relevant price signaling. Weak
econometric evidence, but large support from survey data.
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European Monetary Union
Costs and Benefits of the EMU
Costs
Depends on several factors :
The extent to which the area in question suffers from
asymmetrical shocks (see Reichlin): newer and poorer
countries of the union could have more problems than the
others.
However, opinions are mixed regarding the likelihood of
occurrence of asymmetrical shocks in single currency
zones.
Business cycles might also have adverse effects. Cycles
are the outcome of 3 factors : shocks - propagation
mechanisms - and policy response.
Shocks and cycles could both be costly for the EMU.
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European Monetary Union
European Monetary Policy and ECB
Main goal : provide an institutional structure that helps
to provides the objectives of stability and low inflation
within the union.
The European Central Bank is established in Frankfurt,
according to the Treaty. It is modeled after the US Federal
Reserve System. The ECB is independent from the
governments and dominates the country central banks,
which continue to regulate bank within their borders.
All financial market intervention and the issuance of euros
is the sole responsibility of the ECB.
ECB is free of political pressure (like the Fed and the
Bundesbank) to safeguard the price stability and the antiinflation policy.
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European Monetary Union
Fiscal policy and EMU
Fiscal autonomy is useful to individual countries if they
are affected by asymmetric shocks (since monetary
policy is no longer available).
However, the constraints on the public debt to GDP ratio
limit the fiscal autonomy of the EC members.
In a limited fiscal autonomy framework, the EU central
budget should play a greater role, to
equalise the effect on different regions (transfer fiscal
resources to badly affected regions)
provide an automatic stabilisation for regions suffering
from a temporary loss of income
spread the costs of a adverse shocks over the entire area.
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European Monetary Union
The transition to Euro
Eleven member states of the EU initiated the EMU, adopting
the Euro on Jan 4th 1999, replacing their national currencies
on the financial markets.
Countries are : Austria, Belgium, Finland, France, Germany,
Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain,
and Greece 2 years later. UK, Sweden, and Denmark choose to
keep their national currencies.
The final fixed rates have been determined on Dec. 31, 1998.
The value of Euro against the $ slid steadily following its
introduction, from $1.19 in Jan 1999, to $0.87 in Feb 2002. Its
lowest was $0.825 in Nov. 2000.
The fiduciary introduction of the Euro started Jan 1st, 2002.
Since the spring 2002, the Euro gained in value against the $.
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