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International Monetary Economics
Feb 03 2004
Lesson 1
By
John Kennes
Who is the professor?
Feb 03 2004
Professor: John Kennes
Email: [email protected]
Office: Studiestræde 6
Telephone: 35 32 30 31
Website: www.econ.ku.dk/kennes/
Office hours: by appointment (or just drop by)
What is the teaching language?
Feb 03 2004
English
How are grades determined?
Feb 03 2004
Final written exam
70%
Group projects
30%
What is the textbook?
Feb 03 2004
Baldwin, R and C. Wyplosz (2004) Economics of European
Integration, McGraw-Hill
What is the textbook?
Feb 03 2004
Baldwin, R and C. Wyplosz (2004) Economics of European
Integration, McGraw-Hill
Obstfeld, M. and K. Rogoff (1997) Foundations of International
Macroeconomics, MIT press
What else do we have to read?
Feb 03 2004
See the website and course outline for supplementary readings
What is the course about?
Feb 03 2004
Issues in monetary economics and the interaction of
national economies through international financial
markets.
Topics such as balance of payments, foreign exchange
markets, nominal and real exchange rate determination,
and international parity conditions.
Policy including exchange rate management, optimum
currency areas, the history of international monetary
system, adjustment mechanisms, and currency crises.
List of topics
Feb 03 2004
1.
2.
3.
4.
5.
6.
7.
8.
A monetary history of Europe
The choice of exchange rate regime
European Monetary System
Optimum currency areas
European Monetary Union
Fiscal policy and the stability pack
Financial markets and the Euro
Economic integration and labor market institutions
List of topics
Feb 03 2004
9. Cagan model of money and prices
10. Money in the utility function
11. Cash in advance
12. Mundell-Flemming Dornbusch model
13. Empirical evidence on sticky price models
14. Models of credibility in monetary policy
15. Search theoretic models of money
Why a microeconomist professor?
Feb 03 2004
A reasonable question, however, ...
Why a microeconomist professor?
Feb 03 2004



My research looks at how decentralized agents choose
pricing mechanisms: Auctions versus posted prices
Typical questions in International Monetary Economics
consider optimal flexibility: flexible versus fixed
exchange rates
An early macro model with auctions and posted prices is
by Micheal Parkin
Parkin, M (1986) The Output-InflationTrade-off when Prices are Costly to
Change, Journal of Political Economy
Read for next class*
Feb 03 2004
Laidler, David (1999) The Exchange Rate Regime and Canada’s
Monetary Order, Bank of Canada working paper
Danmarks Nationalbank (2003) Monetary Policy in Denmark
(Pengepolitik i Danmark)
* Can be downloaded from the web
What to think about?
Feb 03 2004
What type of monetary policy does Canada follow?
What are the Bank of Canada’s objectives?
What type of Monetary policy does David Laidler suggest for Canada?
Why?
What type of monetary policy does Denmark follow?
What are Danmarks Nationalbank’s objectives?
Are these the same as the Bank of Canada?
Why (not)?
What to think about?
Feb 03 2004
More questions on the website
www.econ.ku.dk/kennes
Where to start with the textbook?
Feb 03 2004
Very helpful background reading is in chapter 1-3 of Baldwin and
Wyplosz
1.
2.
3.
What has happened in Europe over the past 50 years?
Facts, Law, Institutions and the Budget
Decision making
Chapter 1 is on the internet at the textbook website. (Read sample
chapter)
What has happened in Europe
over the past 50 years?
Feb 03 2004
•
Chapter 1 of Baldwin and Wyplosz illustrates 3 basic things
What has happened in Europe
over the past 50 years?
Feb 03 2004
1. European integration has always been driven by political
factors, ranging from a desire to prevent Franco-German war
to a desire to share the fruit of integration with the newly
democratic nations in Central and Eastern Europe.
– Yet while the goals were always political, the means were
always economic
What has happened in Europe
over the past 50 years?
Feb 03 2004
2. There have been basically three big increases in European
economic integration.
– Formation of the customs union from 1958 to 1968 eliminated
tariffs and quotas on intra-EU trade.
– The Single Market programme implemented between 1986
and 1992 (although elements are still being implemented
today) eliminated many non-tariff barriers and liberalised
capital flows within the EU.
– Finally, the European Economic and Monetary union melded
together the currencies of most EU members.
What has happened in Europe
over the past 50 years?
Feb 03 2004
3. Each of these steps towards deeper integration – but especially
the customs unions and the Single market programme –
engendered discriminatory effects that triggered reactions in
the non-member nations.
– The discriminatory effects of EU integration has created a
powerful gravitational force that has progressively drawn all
but the most reluctant Europeans into the EU.
– If there is a lesson to draw from this for the future, it is that
the 2004 enlargement is likely to greatly magnify the pro-EU
membership forces in the nations further east and south.
Facts, Law, Institutions and the
Budget
Feb 03 2004
•
Chapter 2 of Baldwin and Wyplosz looks at four very different
topics
Facts
Feb 03 2004
•
–
–
A dominant feature of the EU members is their diversity in size
and income levels.
In the EU15, there are only 5 large nations (40 million or more).
The rest, with the exception of the Netherlands, are small or tiny,
with national populations smaller than that of large cities like
Paris or London.
The 2004 enlargement will greatly increase this dispersion since
out of the 10 newcomers, only Poland is large (almost 40 million
citizens).
Facts
Feb 03 2004
–
–
–
The economies of member states are also extremely disparate in
size.
Just 4 of the EU15 economies account for two-thirds of the
EU15’s GDP, i.e. the economies of the other 11 members add up
to only one-third of the EU15’s GDP.
Again this dispersion will greatly widen with the 2004
enlargement. Taking all the 10 newcomers economies together
will add only 5% to the EU15’s current GDP.
Law
Feb 03 2004
•
The EU is unique in that it has a supranational system of law.
That is, on matters pertaining to the European Community, EU
law and the EU Court take precedent over member states’ laws
and Courts.
Institutions and legislative
procedures
Feb 03 2004
•
While there are many EU institutions, only 5 really matter for
most things. These are
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–
–
–
–
the European Council
the Council of Ministers
the Commission
the Parliament
the Court.
These 5 institutions work in concert to govern the EU and to pursue deeper and
wider European economic integration.
Budget
Feb 03 2004
•
The EU budget is rather small, representing only 1% of the
EU15’s GDP. It is spent mainly on
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–
the Common Agricultural Policy (half the budget), and on Cohesion,
resources destined for poor regions in the EU (a third of the budget).
Budget: recipents
Feb 03 2004
•
The budget is funded through four main mechanisms but in the
final analysis, each EU member pays roughly 1% of its GDP. The
distribution of net contributions (receipts minus contributions)
by member state is quite unequal.
–
In the EU15, the biggest net recipients are Luxembourg (the richest
member) and the three poorest members (Greece, Portugal and Spain)
Decision making
Feb 03 2004
Read chapter 3 of Baldwin and Wyplosz to refresh your thinking
about decision making in the Eurozone.
Decision making
Feb 03 2004
Policy making in various areas is categorised into
•
•
•
areas where the EU has ‘exclusive competency’, i.e. where the
decision is made only at the EU level,
areas where competency is shared
areas where the EU has no competency, i.e. where decisions are
made only at the national or sub-national level
Decision making
Feb 03 2004
The allocation of policy areas to these three categories is determined
by the Treaties and decisions of the EU Court of Justice.
•
To clarify the allocation, the EU operates on the principle of
subsidiarity, which says that unless there is a good reason for
allocating a task to the EU level, all tasks should be allocated to
national or sub-national governments.
To centralize or maybe not to
centralize?
Feb 03 2004
Four trade-offs:
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Diversity and information costs favour decentralised decision
making.
Scale economies favour centralisation.
Democracy-as-a-control-device favours decentralisation.
•
Jurisdictional competition favours decentralisation.
A monetary history of Europe
Feb 03 2004
•
Read chapter 10 of Baldwin and Wyplosz
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Also worth reading is Gros and Thygesen (1998)
Why study history?
Feb 03 2004
•
Monetary union is the controversial end of a long process.
History helps understand.
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Since paper money was invented, Europe’s monetary history has
been agitated. Each bad episode carries important lessons.
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Before paper money, Europe was a de facto monetary union.
Understand how it worked helps understand how the new union
works.
Metallic Money
Feb 03 2004
•
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
What is Gresham’s law?
Feb 03 2004
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Bad money drives out good
If two monies circulate alongside each other (eg gold and silver),
and one of the currencies becomes overvalued, it is hoarded, and
the other, depreciated currency is the only one that circulates.
Gold discoveries in the 1850s
How did the Gold Standard
work?
Feb 03 2004
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The workings of the gold standard are described by David Hume’s
price-specie mechanism
Depends on (i) long-run neutrality of money and (ii) the effect of
money on interest rates
Money and the balance of payments are linked by trade flows
Hume’s mechanism implies an automatic change in the money
stock to achieve balance of payments equilibrium
Figure 10.1
Hume’s price-specie mechanism
Feb 03 2004
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Money determines the price level in the long-run.
The price level affects the trade balance
–
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Trade balance is achieved when the stock of money is M1
Hume’s mechanism: Return to balance is automatic
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If we start with deficit (point A, high money stock M ), money flows out
until we get back to balance
Much the same story applies to the financial account
–
•
If domestic prices are relatively high (low), we have a deficit (surplus)
If the domestic interest rate is high (low), capital flows in (out) and the
return to balance is automatic
The balance of payments adds the current and financial accounts
What factors give automaticity?
Feb 03 2004
•
Full convertibility at fixed prices of banknotes issued by central
banks
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Full backing
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So paper money is merely a convenient surrogate to gold
Central bank holds at least as much gold as has been issued in banknotes. In
the presence of gold inflows the central bank prints money, with gold
outflows it retires previously created money.
Complete freedom in trade and capital movements
–
So as not to interfere with the two elements of the adjustment mechanism
How is the Gold Standard related
to the EMU?
Feb 03 2004
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Euro replaces gold since national central banks are no longer
allowed to issue national currencies and there is no exchange rate
Within the Euro-zone, when one country runs a balance of
payment surplus, it receives an inflow euros, and conversely in
the case of a deficit
The Hume mechanism is at work in Euroland
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–
A deficit country can no longer use exchange rate to re-establish
competitiveness, and adjustments will have to work through prices and
wages
The rules of automaticity are part and parcel of Euro area membership
The interwar period
Feb 03 2004
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Money starts circulating widely
Yet the authorities attempt to continue on with the gold standard
but
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No agreement on how to set exchange rate between paper currencies
An imbalanced starting point with war legacies
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High inflation
High public debts
The interwar period: Case
studies
Feb 03 2004
1.
The British Case: A refusal to devalue an overvalued currency
brings economic decline
2. The French Case: Devaluation, undervaluation and beggar-thyneighbor policies, until others retaliate and currency becomes
overvalued
3. The German Case: Hyperinflation, devaluation and finally,
evading the choice of an appropriate exchange rate by resorting
to ever widening non-market controls
Lessons so far
Feb 03 2004
1. We need a system, one way or another
2. The gold standard – monetary unions – delivers automatic return
to equilibrium, but at the cost of booms and Recessions
3. No agreement leads to misalignments, competitive devaluations
and trade wars
4. Agreements require “rules of the game”, including a conductor
Lessons so far
Feb 03 2004
An overriding desire for exchange rate stability
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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
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The timid Snake arrangement
The European Monetary System
The monetary union