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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 Reinert/Windows on the World Economy, 2005 2 Planning the European Monetary Union 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 Reinert/Windows on the World Economy, 2005 3 Table 18.1. The Evolution of the European Union Reinert/Windows on the World Economy, 2005 4 Planning the European Monetary Union 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 Reinert/Windows on the World Economy, 2005 5 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 Reinert/Windows on the World Economy, 2005 6 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 Reinert/Windows on the World Economy, 2005 7 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 Reinert/Windows on the World Economy, 2005 8 Evolution Towards EMU 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% Reinert/Windows on the World Economy, 2005 9 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 Reinert/Windows on the World Economy, 2005 10 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 Reinert/Windows on the World Economy, 2005 11 European System of Central Banks 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 Reinert/Windows on the World Economy, 2005 12 European Central Bank 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 Reinert/Windows on the World Economy, 2005 13 Figure 18.1. Organizational Structure of the ECB Reinert/Windows on the World Economy, 2005 14 The Euro 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 Reinert/Windows on the World Economy, 2005 15 Figure 18.2. The Dollar Value of the Euro, 1999 to 2002 Reinert/Windows on the World Economy, 2005 16 Optimum Currency Areas and Adjustment in the EMU 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 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 Reinert/Windows on the World Economy, 2005 17 Optimum Currency Areas and Adjustment in the EMU 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 Reinert/Windows on the World Economy, 2005 18 Adjustment in the EMU 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 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 Reinert/Windows on the World Economy, 2005 19 The CFA Franc Zone 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 Reinert/Windows on the World Economy, 2005 20 The CFA Franc Zone 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 Reinert/Windows on the World Economy, 2005 21 The CFA Franc Zone 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? 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 Reinert/Windows on the World Economy, 2005 22