Download File - GBM/381 International Trade Instructor: Charissa

An Introduction to
International Economics
Chapter 15: Flexible versus Fixed
Exchange Rates, European Monetary
System, and Macroeconomic Policy
Coordination
Dominick Salvatore
John Wiley & Sons, Inc.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 1
Flexible vs. fixed exchange rates
• The advantages of flexible exchange rates
– External disequilibria are automatically corrected
by exchange rate movements.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 2
Flexible vs. fixed exchange rates
• The advantages of flexible exchange rates
– External disequilibria are automatically corrected by
exchange rate movements.
– Avoid mistaken or distortionary government
determination of exchange rates
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 3
Flexible vs. fixed exchange rates
• The advantages of flexible exchange rates
– External disequilibria are automatically corrected by
exchange rate movements.
– Avoid mistaken or distortionary government
determination of exchange rates
– Are more efficient since resources are not
required to manage the exchange rate system
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 4
Flexible vs. fixed exchange rates
• The advantages of flexible exchange rates
– External disequilibria are automatically corrected by
exchange rate movements.
– Avoid mistaken or distortionary government
determination of exchange rates
– Are more efficient since resources are not required to
manage the exchange rate system
– Provide some insulation to the domestic economy
from external shocks
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 5
Flexible vs. fixed exchange rates
• The advantages of flexible exchange rates
• The advantages of fixed exchange rates
– Encourage greater international trade by reducing
exchange rate risk
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 6
Flexible vs. fixed exchange rates
• The advantages of flexible exchange rates
• The advantages of fixed exchange rates
– Encourage greater international trade by reducing
exchange rate risk
– Impose price discipline by reducing the ability of
the monetary authority to engage in rapid
monetary expansion
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 7
Optimum currency areas
• An optimum currency area is a group of
nations whose national currencies are tied by
permanently fixed exchange rates and operate
under a set of conditions to make this linkage
an optimum.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 8
Optimum currency areas
• An optimum currency area is a group of nations
whose national currencies are tied by
permanently fixed exchange rates and operate
under a set of conditions to make this linkage an
optimum.
• Conditions
– Highly mobile factors of production between the
member nations
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 9
Optimum currency areas
• An optimum currency area is a group of nations
whose national currencies are tied by
permanently fixed exchange rates and operate
under a set of conditions to make this linkage an
optimum.
• Conditions
– Highly mobile factors of production between the
member nations
– Similar national structures
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 10
Optimum currency areas
• An optimum currency area is a group of nations
whose national currencies are tied by
permanently fixed exchange rates and operate
under a set of conditions to make this linkage an
optimum.
• Conditions
– Highly mobile factors of production between the
member nations
– Similar national structures
– Willingness of the nations to coordinate policies
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 11
Optimum currency areas
• An optimum currency area is a group of nations
whose national currencies are tied by
permanently fixed exchange rates and operate
under a set of conditions to make this linkage an
optimum.
• Conditions
• Advantages
– Elimination of exchange rate risk
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 12
Optimum currency areas
• An optimum currency area is a group of nations
whose national currencies are tied by
permanently fixed exchange rates and operate
under a set of conditions to make this linkage an
optimum.
• Conditions
• Advantages
– Elimination of exchange rate risk
– Greater price stability
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 13
Optimum currency areas
• An optimum currency area is a group of nations
whose national currencies are tied by
permanently fixed exchange rates and operate
under a set of conditions to make this linkage an
optimum.
• Conditions
• Advantages
• Disadvantage
– The loss of ability to pursue independent policies
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 14
Steps to European monetary union
• The European Monetary System
• The Maastricht Treaty
• European Monetary Union
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 15
The European Monetary System
• The European Monetary System (EMS),
formed in 1979, set the foundations for later
monetary union of the members of the
European Community.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 16
The European Monetary System
• The European Monetary System (EMS), formed
in 1979, set the foundations for later monetary
union of the members of the European
Community.
• Main features
– Established the European Currency Unit (ECU)
• Weighted average of the currencies of the member
nations
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 17
The European Monetary System
• The European Monetary System (EMS), formed
in 1979, set the foundations for later monetary
union of the members of the European
Community.
• Main features
– Established the European Currency Unit (ECU)
– Established narrow bounds for fluctuation (+/2.25 percent) around established central exchange
rates
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 18
The European Monetary System
• The European Monetary System (EMS), formed
in 1979, set the foundations for later monetary
union of the members of the European
Community.
• Main features
– Established the European Currency Unit (ECU)
– Established narrow bounds for fluctuation (+/- 2.25
percent) around established central exchange rates
– Established the European Monetary Cooperation
Fund
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 19
The European Monetary System
• The European Monetary System (EMS), formed
in 1979, set the foundations for later monetary
union of the members of the European
Community.
• Main features
• Between 1979 and 1992, 11 currency value
realignments were needed.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 20
The European Monetary System
• The European Monetary System (EMS), formed
in 1979, set the foundations for later monetary
union of the members of the European
Community.
• Main features
• Between 1979 and 1992, 11 currency value
realignments were needed.
• In 1993, the fluctuation bounds were increased
to +/- 15 percent.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 21
The Maastricht Treaty
• The Maastricht Treaty, 1991, generated the
agenda by which full monetary union would be
achieved.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 22
The Maastricht Treaty
• The Maastricht Treaty, 1991, generated the
agenda by which full monetary union would be
achieved.
• Stages to monetary union
– Removal of barriers to factor movements within
nations and coordination of macroeconomic
policies
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 23
The Maastricht Treaty
• The Maastricht Treaty, 1991, generated the
agenda by which full monetary union would be
achieved.
• Stages to monetary union
– Removal of barriers to factor movements within
nations and coordination of macroeconomic policies
– Creation of the European Monetary Institute as a
forerunner to the European Central Bank
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 24
The Maastricht Treaty
• The Maastricht Treaty, 1991, generated the
agenda by which full monetary union would be
achieved.
• Stages to monetary union
– Removal of barriers to factor movements within
nations and coordination of macroeconomic policies
– Creation of the European Monetary Institute as a
forerunner to the European Central Bank
– Elimination of domestic currencies
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 25
The Maastricht Treaty
• The Maastricht Treaty, 1991, generated the
agenda by which full monetary union would be
achieved.
• Stages to monetary union
• Conditions for joining the monetary union
– Inflation no higher than 1.5 percent greater than
the average of the three members with the lowest
rates of inflation
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 26
The Maastricht Treaty
• The Maastricht Treaty, 1991, generated the
agenda by which full monetary union would be
achieved.
• Stages to monetary union
• Conditions for joining the monetary union
– Inflation no higher than 1.5 percent greater than the
average of the three members with the lowest rates of
inflation
– A budget deficit no greater than 3 percent of GDP
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 27
The Maastricht Treaty
• Stages to monetary union
• Conditions for joining the monetary union
– Inflation no higher than 1.5 percent greater than the
average of the three members with the lowest rates of
inflation
– A budget deficit no greater than 3 percent of GDP
– Overall government debt no greater than 60
percent of GDP
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 28
The Maastricht Treaty
• Stages to monetary union
• Conditions for joining the monetary union
– Inflation no higher than 1.5 percent greater than the
average of the three members with the lowest rates of
inflation
– A budget deficit no greater than 3 percent of GDP
– Overall government debt no greater than 60 percent
of GDP
– Long-term interest rates not to exceed 2 points
more than the average interest rates of the three
countries with the lowest rates
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 29
The Maastricht Treaty
• Conditions for joining the monetary union
– A budget deficit no greater than 3 percent of GDP
– Overall government debt no greater than 60 percent
of GDP
– Long-term interest rates not to exceed 2 points more
than the average interest rates of the three countries
with the lowest rates
– The average exchange rate not falling by more
than 2.25 percent of the average of the EMS for
the two years prior to joining
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 30
The European Monetary Union
• In 1999, the EMS became the European
Monetary Union.
– Electronic trading of the euro (€) began in 1999.
– Euro notes and coins were introduced in 2002.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 31
The European Monetary Union
• In 1999, the EMS became the European
Monetary Union.
• With European Monetary Union, the European
Central Bank assumed control of monetary
policy for the member countries.
– The main charge of the ECB is to pursue price
stability.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 32
The European Monetary Union
• In 1999, the EMS became the European
Monetary Union.
• With European Monetary Union, the European
Central Bank assumed control of monetary
policy for the member countries.
• Further information on the European Monetary
Union is available on EUROPA, the Internet
portal for the EU government.
– WWW link
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 33
Currency boards
• A currency board arrangement rigidly fixes the
value of a nation’s currency to that of a
foreign currency.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 34
Currency boards
• A currency board arrangement rigidly fixes the
value of a nation’s currency to that of a foreign
currency.
• Advantages
– Reduction in exchange rate risk
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 35
Currency boards
• A currency board arrangement rigidly fixes the
value of a nation’s currency to that of a foreign
currency.
• Advantages
– Reduction in exchange rate risk
– Foreign control over the rate of monetary growth
reduces domestic inflationary pressures
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 36
Currency boards
• A currency board arrangement rigidly fixes the
value of a nation’s currency to that of a foreign
currency.
• Advantages
• Disadvantages
– Complete loss of domestic monetary control
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 37
Currency boards
• A currency board arrangement rigidly fixes the
value of a nation’s currency to that of a foreign
currency.
• Advantages
• Disadvantages
– Complete loss of domestic monetary control
– Loss of ability to seignorage from the creation of
money
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 38
Dollarization
• Dollarization is the adoption of another
nation’s currency as legal tender.
– This is an extreme form of a currency board.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 39
Dollarization
• Dollarization is the adoption of another nation’s
currency as legal tender.
• Advantages
– Elimination of domestic currency exchange rate
risk
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 40
Dollarization
• Dollarization is the adoption of another nation’s
currency as legal tender.
• Advantages
– Elimination of domestic currency exchange rate risk
– External determination of inflation and interest
rates
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 41
Dollarization
• Dollarization is the adoption of another nation’s
currency as legal tender.
• Advantages
– Elimination of domestic currency exchange rate risk
– External determination of inflation and interest rates
– External macroeconomic policy discipline
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 42
Dollarization
• Dollarization is the adoption of another nation’s
currency as legal tender.
• Advantages
• Disadvantages
– Loss of policy independence
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 43
Dollarization
• Dollarization is the adoption of another nation’s
currency as legal tender.
• Advantages
• Disadvantages
– Loss of policy independence
– Cost of obtaining the foreign currency to act as
legal tender
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 44
Other exchange rate systems
• Adjustable peg
– Quasi fixed exchange rate system where
currencies are allowed to fluctuate only in narrow
bounds around the target rate (par value).
– Persistent balance of payments disequilibria
result in revaluation of the currency.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 45
Other exchange rate systems
• Adjustable peg
• Crawling peg
– A system whereby adjustments to the par
currency value are made in small, pre-announced
increments to prevent destabilizing speculation.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 46
Other exchange rate systems
• Adjustable peg
• Crawling peg
• Managed float
– A system where the monetary authority acts to
smooth short-term exchange rate fluctuations
while allowing the currency to move to its longterm trend value.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 47
International macroeconomic policy
coordination
• Given the interdependence of nations,
macroeconomic policies will be more
successful if coordinated.
– This logic lies behind meetings such as the G-8
Summits.
• WWW link to the Canadian government site for the 2004
G-8 Summit
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 48
International macroeconomic policy
coordination
• Given the interdependence of nations,
macroeconomic policies will be more
successful if coordinated.
• International coordination has proven difficult.
Dale R. DeBoer
University of Colorado, Colorado Springs
15 - 49