Download Monetary Unions

Monetary Unions
CHAPTER 18
Reinert/Windows on the World Economy, 2005
Introduction

Options for the exchange rate regime of a country include
 Flexible exchange rate (a “clean” or “dirty” float)
• However, country might be buffeted by destabilizing changes in nominal
(and hence real) exchange rate
 Fixed exchange rate (or crawling peg)
• However, country might eventually stumble into a balance of payments
crisis
 All countries in the RTA could agree to do away with all the exchange
rates by becoming a monetary union with a common currency
• Would still need to decide upon exchange rate regime for common
currency

But can avoid exchange rate instability with major trade and investment
partners
 Policy has been adopted by countries of Western Europe and a group
of African countries with ties to France
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Planning the European
Monetary Union
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History of monetary integration in Europe goes back to the
immediate post-World War II period
Initiative began in 1970 when a commission issued report
providing detailed plan for step-by-step movement to
European Monetary Union by 1980
European Council of Ministers of Economics and Finance
(ECOFIN) endorsed Werner Report in March 1971
Unfortunately subsequent months brought on demise of the
Bretton Woods system of global monetary arrangements
 In response to this crisis members of European Common Market
decide to bind their exchange rates within 2.25% of each other
• Known as “snake in a tunnel” or “snake” which continued through 1978
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Table 18.1. The Evolution of
the European Union
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Planning the European
Monetary Union

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In October 1977, European Commission President
Roy Jenkins called for Europe to adopt monetary
union
In 1978, negotiations began in earnest over the
creation of a European Monetary System
 Came into being as a fixed-rate system in March 1979
 Was an attempt to replicate fixed-rate Bretton Woods

system among countries of Europe
European Currency Unit or ECU was created
• Role equivalent to that initially hoped for SDR in the Bretton
Woods system
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Planning the European
Monetary Union

Original hope was that each country would
peg their currency to ECU
 Instead, in 1980s countries began to peg their
currencies to German mark
 ECU continued only as a unit of account for
official European Community business
 Great deal of instability in the early years of the
ECU
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Planning the European
Monetary Union

In April 1989 President of the European
Commission, Jacques Delors, issued a
report
 Called for a single currency and an integrated
system of European central banks
 Maastricht Treaty, agreed to in December 1991,
was to serve as a constitution of new European
Union, replacing Treaty of Rome
• Set 1999 as a target date for a European Monetary
Union or EMU
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European Monetary Institute

In 1994 a European Monetary Institute (EMI)
came into being with the purpose of
 Planning for future European System of Central
Banks or ESCB
 Plot course towards monetary integration
 Monitoring progress of member countries toward
meeting a set of convergence criteria
• Concerning price stability, levels of government
deficits and debt, exchange rate targets, and interest
rate targets
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Evolution Towards EMU

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Proved to be more difficult than envisioned in the Delors
report
In 1990, East and West Germany had reunified
 Required unprecedented increases in public expenditure on part of
German government
 To prevent German economy from expanding too quickly, central
bank pursued a tight or restrictive monetary policy
• Kept German interest rate high, caused international investors to favor
•
•
mark-denominated assets over other European assets, and put
downward pressure on value of other European currencies
EMS par-value system came under pressure
Difficulties in ratification of 1992 Maastricht Treaty ruffled investors’
expectations

Growing predictions of a “no” vote (proved to be incorrect) in French
referendum on Maastricht in September 1992
 Other currencies values were also forced outside of EMS
• In response, margins around parities were expanded from 2.25% to 15%
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Evolution Towards EMU
British government subsequently opted out of
EMU
 However, most EU leaders pressed on
 Committed themselves to introducing a common

currency, called the euro
 Adopted EMI’s plan for monetary integration
despite widespread misgivings
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Implementing the European
Monetary Union

In 1997 European Union adopted Stability and
Growth Pact
 Places restrictions on EMU member countries’ fiscal

policies
In 1998, EU leaders determined countries which were to
take part in the EMU/euro
• Austria, Belgium, Finland, France, Germany, Ireland, Italy,
Luxembourg, the Netherlands, Portugal, and Spain

Reflected extent to which countries met the convergence criteria
• Greece wanted to join but was not allowed to—decision was later
reversed
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European System of Central
Banks
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Centerpiece of EMU
 European Central Bank (ECB)
 Former national central banks in a structure modeled


quite closely on Federal Reserve System of United
States
Primary goal is conduct of monetary policy to maintain of
price stability within EMU
Required to maintain annual increases in a Harmonized
Index of Consumer Prices (HICP) at or below 2%
• Widely regarded as a very stringent rule, but one insisted upon
by German central bank
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European Central Bank
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Headed by a President with an eight-year, non-renewable
term
European Council appoints ECB President, and a battle
ensued over who would fill this post
Executive Board is composed of Vice President and four
other individuals
 Responsible for implementing monetary policy within EMU
Executive Board and other heads of EMU member central
banks compose ECB Governing Council
 Governing Council is responsible for formulating monetary policy
within EMU
 General Council that adds the 4 heads of EU member central banks
that are not part of EMU
• Administrative body that is responsible for work previously undertaken
by EMI
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Figure 18.1. Organizational
Structure of the ECB
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The Euro
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Launched in January 1999
EMU member exchange rates became “irrevocably” locked
Monetary policy was transferred to ECB
 Capitalized at 5,000 million euros with subscriptions from central
banks of all EU countries

Value initially set at $1.186 in a flexible exchange rate
regime
 By June 1999, value had fallen to nearly $1.00
• Reflects the flexible exchange rate regime

In January 2002, ECB introduced euro notes and coins
 Began process of withdrawing old notes and coins from circulation
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Figure 18.2. The Dollar Value
of the Euro, 1999 to 2002
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Optimum Currency Areas and
Adjustment in the EMU
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Optimum currency area is a collection of countries
characterized by
 Well-integrated factor markets
 Well-integrated fiscal systems
 Economic disturbances that affect each country in a
symmetrical manner
• For example United States constitutes an optimum currency area
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Labor and physical capital are mobile among the states
Great deal of integration of fiscal systems through federal
government
Cycles of recession and recovery tend to affect each region in a
somewhat symmetrical manner
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Optimum Currency Areas and
Adjustment in the EMU
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Seems to be less evidence that EMU is an
optimum currency area
 Both labor and physical capital are less mobile
than in United States
 Budget is relatively small in proportion to size of
the economies involved
 Business cycles among members of the EMU
are somewhat asymmetrical
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Adjustment in the EMU
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The absence of an optimum currency area is troublesome
 In a face of a recession in one country, unemployment will rise
• Rise in unemployment can be addressed in four ways
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An overall decline in wage rates leading to increases in quantity demanded
for labor
 Can in principle address unemployment problems
 However, wages in most EMU countries are notoriously “downward
inflexible”
Labor mobility out of areas of unemployment
 Could likewise help achieve adjustment; however labor mobility within
EMU is not very strong
Expansionary monetary policy (at EU level)
 However, ECB is required to maintain annual increases in a
Harmonized Index of Consumer Prices at or below 2%
Expansionary fiscal policies (at member country level)
 However, under EU’s Growth and Stability Pact, convergence criteria
have evolved into rules setting limits to fiscal policy of member
countries
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The CFA Franc Zone
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A complete and functioning monetary union among
13 member countries
 Have adopted CFA franc as a common currency
 In existence since 1945
Economic performance (until mid 1980s) was no
worse than and perhaps better than neighboring
countries with floating or managed floating
exchange rates
Central Bank for West African States and Bank for
Central African States maintain a foreign exchange
reserve pool
 Keep 65% of their reserves with French Treasury
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The CFA Franc Zone
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Fixed peg to French franc
 Strategy worked up to mid-1980s
• World prices of main CFA export goods declined significantly
• Countries involved found themselves in balance of payments
difficulties
• Devaluation was not a possibility and adjustment was attempted
by contractionary macroeconomic policies

Aimed at reducing import demands and maintaining high interest
rates
• Some CFA members began to turn to IMF for assistance
• Devaluation of 50% against French franc was made in January
1994
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The CFA Franc Zone
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With launch of euro in 1999, franc peg became a
euro peg
 Makes some economic sense since EU is CFA franc
zone’s main trading partner
Key question: Can CFA franc-euro peg be maintained?
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Important lesson
 A monetary union, despite resolving exchange rate
difficulties among its members, still can involve difficulties
in relationship of common currency with rest of the world
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