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Theorie und Politik der
Europäischen Integration
Theory and Politics of
Eropean Integration
Lecture 6
A Monetary History of Europe
Choice of Exchange Rate Systems
Optimum Currency Areas (Start)
Prof. Dr. Herbert Brücker
Theory and Politics of European Integration
A Monetary History of Europe
Last Lecture
•
•
Growth effects, capital and labour market integration
Growth effects
· Static and dynamic effects of integration
· Static: allocation effects
· Neoclassical (Solow) growth model: temporary growth
effects, in steady state higher income level
· Endogenous growth models: continuous growth effects via
higher investment in physical and human (knowledge)
capital which increases rate of technological progress
· Empirical evidence: higher transitional growth through
integration
•
Capital market integration
· Integration equalises capital endowments and interest rates
· Creates winners and loses in sending and receiving
countries
· Aggregate income gain
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Last Lecture
•
Labour market integration
·
·
·
·
Institutions
Scale of migration and income differences
Composition of migrants, self-selection and out-selection
Labour market impact
– Standard model with perfect labour markets
– Equalisation of wage rates
– Aggregate gains, but winners and losers
– More complex models:
– Capital stock adjustment
– Wage rigidities and unemployment
– Empirical evidence
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
This lecture: Monetary Integration I
• A monetary history of Europe
•
Metallic money
•
The gold standard
•
The interwar period
•
The post-wa<r period: from Bretton Woods to EMU
• Choice of an exchange rate regime
•
Exchange rate and monetary policy
•
The range of exchange rate policies
•
Choices
· Criteria
· Fix or float?
· Regional arrangements
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Why studying history?
•
•
•
Monetary union is the controversial end of a long
process. History helps understand.
Since paper money was invented, Europe’s monetary
history carries important lessons. Particularly the bad
ones.
Before paper money, Europe was a de facto monetary
union. Understand how it worked helps understand how
the new union (EMU) works.
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Metallic Money
•
•
•
•
Under metallic money (overlooking the difference
between gold and silver) the whole world was really a
monetary union
Seignorage as key source of public finance
· ‘shaving’ as a means to generate revenues
Multiplicity of money
Previous explicit unions only agreed on the metal content
of coins to simplify everyday trading
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Metallic Money: Some Details
• From immemorial until 19th century metallic money (gold or
silver) dominant means of payment
• Bimetallism (gold and silver) with fluctuating exchange rates
depending on discoveries
• Monetary unions as a tool of nation-building
• e.g. Germany: before 1871 different monetary standards
• Two historical monetary unions
• Latin Monetary Union (BE, FR, IT) to preserve bimetallism
• Scandinavian Monetary Union ceased at WWI
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Gold standard
• Classic gold standard period 1880-1914
• Frequent financial crises, armed conflicts and depressions
• Working of the gold standard: Hume’s “price-speciemechanism”
• (“specie” = money/gold)
• Key assumptions or macroeconomic principles
• long-run neutrality of money
· rate of inflation is driven by rate of money growth
• effect of money on interest rates
• Helps to understand working of EMU
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Neutrality of money and current account equilibrium
price
level
A
current account deficit
P1
current account surplus
M1
M0
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
gold money
Theory and Politics of European Integration
A Monetary History of Europe
Neutrality of money and current account equilbrium
price
level
Money determines the
price level (in the long run)
A
current account deficit
P1
current account surplus
M1
M0
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
gold money
Theory and Politics of European Integration
A Monetary History of Europe
Neutrality of money and current account equilbrium
price
level
A
current account deficit
P*
current account surplus
M1
M0
Price level affects the trade balance
• If domestic prices are
high relative to foreign
prices, we have a deficit
• Conversely, relatively
lowgold
domestic
prices lead
money
to a trade surplus
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Neutrality of money and current account equilbrium
price
level
A
current account deficit
P1
current account surplus
Trade balance is achieved when
the stock of money is M1, and,
hence, domestic prices equal P*.
M1
M0
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
gold money
Theory and Politics of European Integration
A Monetary History of Europe
Balance of payment equilibrium
BoP
0
C
A
M0
inflow of money
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
B‘
B
gold money
outflow of money
Theory and Politics of European Integration
A Monetary History of Europe
Balance of payment equilbrium
BoP
Hume’s mechanism: return to balance is automatic.
• If we start with a high money stock (e.g. point B),
domestic prices are high, balance of payments turns in
deficit and gold flows out, but commodities in (current
account
surplus)
C
• Why? We have to buy other goods by gold.
A
0
M0
inflow of money
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
B‘
B
gold money
outflow of money
Theory and Politics of European Integration
A Monetary History of Europe
Balance of payment equilbrium
BoP
0
• If we start with a low money stock (e.g. point C),
balance of payments turns in surplus and gold flows in,
• but commodities out (current account deficit)
C
A
M0
Point A correesponds to
price level P* and money
supply M1 in first graph,
gold money
where current
account is
B‘
in equilbrium
B
inflow of money
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
outflow of money
Theory and Politics of European Integration
A Monetary History of Europe
Financial account equilibrium
interest
rate
A
financial account surplus
financial account deficit
i*
M0
M2
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
gold money
Theory and Politics of European Integration
A Monetary History of Europe
Financial account equilibrium
interest
rate
A
financial account surplus
financial account deficit
i*
Much the same story applies to the financial account:
• if the stock of money increases, the domestic interest
rate declines
• if the interest rate is below the international rate i*, it
pays to borrow gold at home and ship it abroad, i.e.
M0
M2
gold money
capital flows out
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Financial account equilibrium
interest
rate
A
financial account surplus
financial account deficit
i*
Thus, if i > i*, capital account is in surplus, and
if i < i* it turns into a deficit
• Equilibrium is achieved if i = i*
M0
M2
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
gold money
Theory and Politics of European Integration
A Monetary History of Europe
Financial account equilibrium
interest
rate
A
financial account surplus
financial account deficit
i*
Relation between financial and current account:
• Capital inflow increases interest rate and prices
•Both capital and current account deteriorate
•Trade route is slower, but both work in same direction
M0
M2
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
gold money
Theory and Politics of European Integration
A Monetary History of Europe
Monetary equilibrium under gold standard
• Money in excess of M0 translates into balance of payment
deficits and gold outflows
• If money is in short supply (left of A = M0), balance of
payments is in surplus and gold flows in
• Point A may correspond to a point with imbalances in current
and capital account, e.g. a point where the current account
deficit exactly matches the capital account surplus
• Thus, the gold standard results in a balance of payments
equilibrium in the long-run, but not (necessarily) a current
account or capital account equilibrium
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Monetary equilibrium under gold standard
• Financial markets support equilibrium: if money supply
declines, interest rate increases, which attracts capital
• Over time, if a country is in short supply of gold money
supply stringency creates increasing interest rates, growth
slow-down, higher unemployment and a downward pressure
on prices and wages
• All markets contribute to eliminate external imbalance, no
need for government intervention (in theory)
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Rules of the game and problems
• Full gold convertibility at fixed price of all banknotes
• Full backing. Central Bank holds same amount of gold as
notes issued
• Complete freedom of trade and capital mobility
• Problems:
• Sticky prices and wages (short-term disequilibria)
• World money supply driven by discoveries and money
demand driven by economic growth go not hand in hand
• Governments facing deficits tend to opt out of gold
standard
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Similarities to the EMU
• EURO replaces gold (no national money supply)
• Hume’s mechanism works in Eurozone:
• Balance of payments surplus translates into EURO inflows
• Balance of payments deficit translates into EURO outflows
• Exchange rate cannot be used to equilibrate external
deficits
• Adjustment has to work via prices and wages
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
The interwar period: the worst of all worlds
• Shipping gold became too dangerous and 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
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
The interwar period: three case studies

The British case: return to gold standard pre-war parity and refusal to
devalue an overvalued currency relative to US breeds economic
decline. Abolished unsustainable gold standard in 1931 and devalued
currency by 30%. Cost: decade of miserable growth.
 The French case: high debts hoping for German’s reparations,
inflation soared after reparations failed. Return to gold standard and
devaluation in 1928; undervaluation and beggar-your-neighbour
policies protected economy first, but then others retaliate and the
currency becomes overvalued, badly hit by Great Depression.
• The German case: hyperinflation, gold standard no option
(reparations), devaluation and anti-inflation policy in 1924, turns into
overvaluation in the early 1930s, and, finally, evading the choice of an
appropriate exchange rate by resorting to ever-widening non-market
controls under Nazi government.
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Lessons so far
 We need a system, one way or another
• The gold standard – monetary unions – delivers automatic
return to equilibrium, but at the cost of booms and
recessions
• No agreement leads to exchange rate misalignments,
competitive devaluations and trade wars
• Domestic misbehaviour undermine fixed exchange rates such
as gold standard
• Exchange rate agreements require “rules of the game”,
including a conductor, e.g. city of London before WW I
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
European post-war 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
• Gold convertibility of US-$: 35 US-$ per ounce
• Once Bretton Woods collapsed, the Europeans were left on
their own
• The timid Snake arrangement
• The European Monetary System
• The European Monetary Union
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
European postwar arrangements (cont.)
 The Bretton Wood collapse
• Financing the Vietnam war by public debt which fueled
inflation and created large current account deficits
• Diverging inflation rates and real appreciation pressures
of many currencies (e.g. DM)
• Suspension of gold convertibility and realignment 1971
(devaluation of 10 %)
• Collapse 1973
• The Snake arrangement
• Agreeing on stabilizing intra-European bilateral parities
• No enforcement mechanism: too fragile to survive
• Diverging inflation rates across European countries
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
The EMS: Super Snake
 Complements bilateral exchange rate commitments with a
•
•
•
•
support mechanism
Allows for prompt realignments to avoid misalignments
Emergence of the DM as the system’s anchor
But, still inflation divergence and misalignments kept
growing
1992-93 speculative attacks alsmost destroyed EMS, IT and
UK left, realignments of IR, ESP, PT
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
From EMS to EMU (EURO)
 EMS de facto doomed
• Convergence to Bundesbank standards means that all other
countries lost monetary independence
• Delors report prepared European Monetary and Financial
Union, plan for common currency
• EMU plan adopted at Maastricht Summit 1989
• 1999 exchange rates were irrevocably frozen, 2002 Euro
notes and coins were circulatred
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Lessons from history
Gold
standard
Interwar
Bretton
Woods
EMS
EMU
Long-lasting
misalignments must
be avoided
Yes
(automatic)
Yes
Yes
(not
possible)
Systems need to be
built coherently
Yes
Yes
Yes
Yes
Policy misbehaviour is
ruled out
(largely)
Yes
Systems must able to
cope with shocks
Conductor existing
Yes
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Yes
Yes
Yes
Yes
Yes
Theory and Politics of European Integration
A Monetary History of Europe
The choice of an exchange rate regime
An question and the answer
• The question: what to do with the exchange rates: fixed or
flexible?
• Viewpoint of an individual country, in contrast to systems
• Underlines the principles to evaluate the merits of a
monetary union
• The answer: there is no best arrangement
• A matter of trade-offs
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Three basic principles
1
Long term: neutrality of money and PPP
2
Short term: non-neutrality of money, real and monetary
matters interfere (cyclical fluctuations and shocks)
3
Interest parity condition
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
The long-term neutrality of money: theory
Inflation
rate
AD
long-term AS
AD
short-term AS
AD: Why downward
sloping?
Inflation erodesC
purchasing power of
money and
discourages
B
consumption and
investment
A
0
output gap
The AS-AD model output gap (Actual – Trend GDP)
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
The long-term neutrality of money: theory
Inflation
rate
AD
long-term AS
AD
short-term AS
AS: Why upward
sloping?
C
B
Depression results in
lower wages and
lower prices of firm,
while boom results in
higher wage and
price pressures
A
0
output gap
The AS-AD model output gap (Actual – Trend GDP)
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
The long-term neutrality of money: theory
Inflation
rate
AD
long-term AS
AD
short-term AS
Long-run:
C
B
A
0
If prices rise faster
than wages,
purchasing power
declines, creates
wage pressure,
eventually we move
back to long-run
wage-price relation at
C.
output gap
The AS-AD model output gap (Actual – Trend GDP)
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Long term neutrality implication: PPP
• The real exchange rate
• Defined as  = EP/P*
• E = nominal exchange rate; P = domestic price;
P* = foreign price
• Purchasing Power Parity (PPP): E offsets changes in P/P*
• So  is constant
• Many caveats, though:
• PPP seems to hold in the long run, but not in
the short and medium run
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Short term non-neutrality of money
• From AD-AS: the short-run AS schedule
• So monetary policy matters in the short run
• Channels of monetary policy
• The interest rate channel
• The credit channel
• The stock market channel
• The exchange rate channel
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Monetary policy in the IS-LM model
interest
rate
foreign
level
LM
A
B
LM‘
D
IS‘
C
IS
Output-gap
(Actual-Trend GDP)
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Monetary policy in the IS-LM model
interest
rate
LM
1.
2.
3.
4.
Foreign
level
LM‘
increase in money supply moves LM to LM‘,
interst rates declines initially to B,
spending expands and economy moves to C
capital flows out until interest rate is back
to international level
A
B
D
IS‘
C
IS
Output-gap
(Actual-Trend GDP)
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Monetary policy in the IS-LM model
interest
rate
LM
LM‘
Flexible exchange rate:
• currency depreciates
• current account improves
(IS shifts to IS‘)
• output moves eventually to D
Foreign
level
A
B
D
IS‘
C
IS
Output-gap
(Actual-Trend GDP)
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Monetary policy in the IS-LM model
interest
rate
LM
LM‘
Fixed exchange rate:
• Central Bank must intervene in exchange
market
• money supply shrinks until LM curve
shifts back from LM‘ to LM and output to A
Foreign
level
A
B
D
IS‘
C
IS
output-gap
(Actual-Trend GDP)
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Monetary policy in the IS-LM model
interest
rate
LM
LM‘
Thus, there is no room for
monetary policy with a fixed
exchange rate!
Foreign
level
A
B
D
IS‘
C
IS
output-gap
(Actual-Trend GDP)
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Fiscal policy in the IS-LM model
interest
rate
LM
LM‘
B
Foreign
level
A
C
IS‘
IS
Output-gap
(Actual-Trend GDP)
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Fiscal policy in the IS-LM model
interest
rate
LM
LM‘
B
Foreign
level
A
C
IS‘
1.
2.
3.
4.
5.
Fiscal policy shifts IS curve to IS’.
IS
LM stays where it is.
Output-gap
Output moves to B.
(Actual-Trend
The interest rate rises above foreign
level. GDP)
Capital flows in to restore interest parity
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Fiscal policy in the IS-LM model
interest
rate
LM
LM‘
B
Foreign
level
A
C
IS‘
Fixed exchange rate:
IS
• Central Bank intervenes to prevent currency appreciation
Output-gap
• sells money such that increased money supply
shifts LM to LM’
(Actual-Trend GDP)
• economy moves eventually to point C
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Fiscal policy in the IS-LM model
interest
rate
LM
LM‘
B
Foreign
level
A
C
IS‘
IS
Flexible exchange rate:
Output-gap
• Capital flows in and currency appreciates
(Actual-Trend GDP)
• Current account worsens
• Demand
declines
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere
Integration Europäischer
Arbeitsmärkte
• Eventually,
IS’ shifts
back
to IS and the economy back to A
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Fiscal policy in the IS-LM model
interest
rate
Foreign
level
LM
LM‘
Thus, fiscal policy does
only work under fixed
exchange rates in small
open economies B
A
C
IS‘
IS
Output-gap
(Actual-Trend GDP)
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Exchange rate regimes and policy effectiveness
Monetary
policy
Fiscal policy
Fixed
exchange
rate
Ineffective
Effective
Flexible
exchange
rate
Effective
Ineffective
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
When does the regime matter?
• In the short run, changes in E are mirrored in
changes in  = EP/P*: P and P* are sticky
• In the long run,  is independent of E: P adjusts
• If P is fully flexible, the long run comes about
immediately and the nominal exchange rate does
not affect the real economy
• Put differently, the choice of an exchange rate
regime has mostly short run effects because prices
and wages are sticky
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
What’s on the menu?
•
•
•
•
•
•
•
•
Free floating (e.g. US, Eurozone)
Managed floating (e.g. Japan)
Target zones (e.g. ‘snake’)
Crawling pegs (e.g. Poland under transition)
Fixed and adjustable (e.g. Bretton Woods +-1%)
Currency boards (e.g. Estonia, Lithuania in 1990s)
Dollarization/Euroization
Monetary union
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
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 politicized
• Can be misused (public debts, political cycles)
• Exchange rate stability
• Freely floating exchange rates move “too much”
• Fixed exchange rates eventually become misaligned
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
The old debate: fixed vs. float
• The case for flexible rates
• With sticky prices, need exchange rate flexibility to deal
with shocks
• Remove the exchange rate from politicization
• Monetary policy is too useful to be jettisoned
• The case for fixed rates
• Flexible rates move too much (financial markets are often
hectic)
• Exchange rate volatility: a source of uncertainty
• A way of disciplining monetary policy
• In presence of shocks, always possible to realign
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
The new debate: the two-corners solution
• Only pure floats or hard pegs are robust
• Intermediate arrangements (soft pegs) invite government
manipulations, over or undervaluations and speculative
attacks
• Pure floats remove the exchange rate from the policy
domain
• Hard pegs are unassailable (well, until Argentina’s currency
board collapsed…)
• In line with theory
• Soft pegs are half-hearted monetary policy commitments,
so they ultimately fail
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
The two-corners solution and the real world
• Fear of floating
• Many countries officially float but in fact
intervene quite a bit
• Fear of fixing
• Many countries declare a peg but let the
exchange rate move out of official bounds
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Fear of floating
140.00
130.00
Denmark (vis a vis €)
Sweden (vis a vis €)
Switzerland (vis a vis €)
Korea (vis a vis $)
120.00
110.00
100.00
90.00
80.00
1999M1 1999M7 2000M1 2000M7 2001M1 2001M7 2002M1 2002M7 2003M1 2003M7
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
The two-corners solution and the real world
• Fear of floating is deeply ingrained in many
European countries
• Fear of fixing partly explains the disenchantment
with the EMS and some reluctance towards
monetary union
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
Conclusions
• A menu hard to pick from: trade-offs are
everywhere
• All of this takes the view from a single country
• Systems involve many countries and rest on agreed
upon rules, including mutual support
• Since the end of Bretton Woods, there is no world
monetary system
• This leaves room for regional monetary systems.
Enters Europe’s experience
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration
A Monetary History of Europe
NEXT LECTURE
•
•
Optimum Currency Areas
Reading: Baldwin/Wyplosz (2006, Ch. 16)
Prof. Dr. Herbert Brücker
Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte
Universität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker