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INTERNATIONAL MONETARY
AND
FINANCIAL ECONOMICS
Third Edition
Joseph P. Daniels
David D. VanHoose
Copyright © South-Western, a division of Thomson Learning. All rights reserved.
Chapter 15
Policy
Coordination,
Monetary
Union, and
Target Zones
Structural Interdependence
• Structural interdependence is the reason that
policymakers might consider the joint
determination of economic policies.
• Structural interdependence refers to the
interconnectedness of nations’ markets for
goods and services, financial markets and
payments systems.
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International Policy Externalities
• Structural interdependences can results in
international policy externalities: a benefit or cost
for one nation’s economy owing to a policy
undertaken in another economy.
• A locomotive effect occurs when an increase in
real income in one economy spurs an increase in
real income in another.
• A beggar-thy-neighbor effect occurs when a policy
action benefits the residents of the home country
at the expense of residents in another nation.
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International Policy Cooperation
and Coordination
• There are two ways that nations may work together to
achieve their economic objectives.
• International Policy Cooperation is the adoption of
institutions and procedures by which policymakers
can inform each other of their objectives and share
data.
• International Policy Coordination is the joint
determination of economic policies within a group of
nations, intended to benefit the whole.
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Aggregate Demand Effects of a
Domestic Monetary Expansion
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An Example of a Two-Country
Monetary Policy Conflict
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Potential Benefits of International
Monetary Policy Coordination
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Potential Benefits of Coordination
1. Take account of and minimize policy
externalities
2. Achieve a larger number of policy objectives
with available instruments
3. Policymakers may present a “united front” in
the face of home political pressures that
could push them to adopt harmful policies.
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Potential Drawbacks to
Policy Coordination
1. Must sacrifice or forego some domestic
interests
2. Must trust that counterparts are willing to
make sacrifices
3. Coordinated policies may have negative
consequences such as higher inflation (e.g.,
Bonn Summit of 1978)
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Hypothetical Welfare Levels for
Two Nations
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Discretionary Inflation Bias with
Noncoordinated Monetary Policies
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Discretionary Inflation Bias with
Coordinated Monetary Policies
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Monetary Unions
• An extreme type of coordination is for a nation
to give up its own currency and adopt a
currency common to it and a coalition of other
nations.
• That is, form a monetary union.
• For a monetary union to succeed, the coalition
must represent an optimal currency area.
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Optimal Currency Area
• The theory of optimal currency areas is a means of
determining the size of a geographic area within
which residents’ welfare is greater if their
governments fix exchange rates or adopt a common
currency.
• An optimal currency area is on in which labor is
sufficiently mobile to permit speedy adjustments to
payments imbalances and regional unemployment so
that exchange rates can be fixed or a common
currency adopted.
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Vehicles Currencies
• A Vehicle Currency is a currency that individuals and
businesses most often use to conduct international
transactions.
• Since the end of World War II, the U.S. dollar has
been the dominant vehicle currency.
• The U.S. dollar is used to denominate over 60 percent
of banks’ cross-border positions, nearly one-third of
international money market instruments and almost
45 percent of international notes and bonds.
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Exchange Rate Target Zones
• A target zone is a “intermediate” approach to
exchange rate management that limits
exchange rate volatility while still permitting
some variation in countries currency values.
• Specifically, a target zone is a range of
permitted exchange rate variation between
upper and lower exchange rate bands that a
central bank defends by purchasing or selling
foreign exchange reserves.
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An Exchange Rate Target Zone
A target zone is a range within which a
central bank permits the exchange rates to
vary. If the exchange rate approaches the
upper band SU, then the central bank sells
foreign exchange reserves in sufficient
quantities to prevent additional depreciation
of its nation’s currency. In contrast, if the
exchange rate approaches the lower band SL,
then the central bank purchases sufficient
amounts of foreign exchange reserves to
stem any further currency appreciation.
Between the upper and lower bands,
however, the central bank does not intervene
in the foreign exchange market.
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The Behavior of the Exchange Rate
within a Target Zone
An oversimplified view of how the
exchange rate might vary inside a target
zone is that it floats along this dashed line
within the target zone, with fixed
exchange rate limits at the top and
bottom of the zone. In fact, however,
speculators in the foreign exchange
market alter their demands for the
nation’s currency if they anticipate a
central bank intervention near either band
of the zone. Hence, the equilibrium
exchange rate in a target zone actually
should lie below the dashed line as the
exchange rate approached the upper
band of the zone and above the dashed
line as the exchange rate approaches the
lower band of the zone As a result, the
equilibrium exchange rate should lie
along a smooth, S-shaped curve.
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