CHAPTER T W E N T Y 20

CHAPTER T W E N T Y 20

CHAPTER T W E N T Y 20 International Economics Tenth Edition Flexible versus Fixed Exchange Rates, the European Monetary System, and Macroeconomic Policy Coordination Dominick Salvatore John Wiley & Sons, Inc.

Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Learning Goals: Identify the advantages and disadvantages of fixed and flexible exchange rates Understand the meaning of an optimum currency area Describe the creation of the euro and the operation of the European Central Bank

Describe adjustable pegs, crawling pegs, managed floating, and how they work Know the meaning and importance of macroeconomic policy coordination Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Introduction Advocates of a fixed exchange rate system argue for the certainty and stability of fixed rates, while advocates of a flexible rate claim more efficiency in correcting balance of payments

disequilibria. There is no clear-cut conclusion about whether fixed or flexible exchange rates are superior. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. The Case for Flexible Exchange Rates A flexible exchange rate system is said to be more efficient than a fixed exchange rate system because: 1.

It relies only on changing exchange rates, not prices, to adjust balance of payments. 2. It makes adjustments smooth and continuous rather than occasional and large. 3. It clearly identifies the nations degree of comparative advantage and disadvantage in various commodities.

Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. The Case for Flexible Exchange Rates The policy advantages of a flexible exchange rate system: It frees monetary policy for domestic goals. 2. It enhances the effectiveness of monetary policy. 3. It allows each nation to pursue its own inflation-unemployment trade-off. 4. It removes the danger that the

government will use the exchange rate to reach goals better achieved by other policies. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. 1. The Case for Fixed Exchange Rates The case for fixed exchange rates rests on: 1. Less uncertainty than flexible rates.

2. Speculation likely to be more stabilizing than flexible rates. 3. Flexible rates do lead to excessive volatility in exchange rates. Empirical evidence suggests that a flexible system does not compare unfavorably with a

fixed rate system with respect to whether speculation is stabilizing or destabilizing. Less inflationary than flexible rates. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. FIGURE 20-1 Shifts in the Nations Demand Curve for Foreign Exchange and Uncertainty. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. FIGURE 20-2 Fluctuations in Exchange Rate in the Absence of Speculation and with Stabilizing and Destabilizing Speculation. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc.

The Open- Economy Trilemma A fixed exchange rate, unrestricted capital flows, and monetary independence cannot all be achieved at the same time. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Optimum Currency Areas, the European Monetary System, and the European Monetary Union

An optimum currency area is a group of nations whose national currencies are tied by permanently fixed exchange rates. Conditions that make optimum currency area optimum: Greater mobility of resources among member nations Greater structural similarities Greater willingness of the nations to coordinate fiscal, monetary and other Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc.

policies Optimum Currency Areas, the European Monetary System, and the European Monetary Union Benefits of optimum currency area: Eliminates exchange rate uncertainty, stimulating specialization in production and flow of trade and investments.

Encourages producers to view entire area as single market, benefitting from greater economies of scale. Provides greater price stability as price shocks in different regions cancel each other out. Saves cost of official interventions in foreign Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. exchange markets, cost of hedging, and cost

Optimum Currency Areas, the European Monetary System, and the European Monetary Union Disadvantage of optimum currency area: Member nations cannot pursue independent stabilization and growth policies for their particular circumstances.

Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Optimum Currency Areas, the European Monetary System, and the European Monetary Union The European Monetary System (EMS), formed in 1979, laid the foundations for later monetary union of the members of the European Community. Main features: Established the European Currency Unit (ECU),

weighted average of member currencies. Established narrow bounds for fluctuation (+/2.25%) around parity, establishing fixed but adjustable exchange rate system. Established the European Monetary Cooperation Salvatore: International Economics, Edition 2013 John Wiley & Sons, Inc. Fund11thto provide

balance of payments assistance to Optimum Currency Areas, the European Monetary System, and the European Monetary Union The Maastricht Treaty, 1991, generated the agenda by which full monetary union would be achieved. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Optimum Currency Areas, the

European Monetary System, and the European Monetary Union Stages to monetary union: 1. Coordination of macroeconomic policies and removal of barriers to capital movements within nations. 2. Creation of the European Monetary Institute as a forerunner to the European Central Bank. 3. Establishment of a single currency and European Central Bank for foreign exchange market interventions and open market operations. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc.

Optimum Currency Areas, the European Monetary System, and the European Monetary Union Conditions for joining the monetary union: 1. Inflation no higher than 1.5 percent greater than the average of the three members with the lowest rates of inflation.

2. A budget deficit no greater than 3 percent of GDP 3. Overall government debt no greater than 60 percent of GDP. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Optimum Currency Areas, the European Monetary System, and the

European Monetary Union Conditions for joining the monetary union: 4. Long-term interest rates not to exceed 2 points more than the average interest rates of the three countries with the lowest rates. 5. 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. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Optimum Currency Areas, the European Monetary System, and the European Monetary Union Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Optimum Currency Areas, the European Monetary System, and the

European Monetary Union The European Central Bank and the Common Monetary Policy The European Central Bank (ECB) is the operating arm of the European System of Central Banks Established with the sole goal of pursuing price stability. Independent of the European Parliament. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Currency Boards Arrangements and

Dollarization Under a currency board arrangement, a nation rigidly fixes the exchange rate of its currency to a foreign currency, and its central bank ceases to operate as such. A currency board is the most extreme form of exchange rate peg short of adopting a common currency. Usually done when nation is in deep financial crisis, and to combat inflation.

Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Currency Boards Arrangements and Dollarization Advantages: Reduction in exchange rate risk. Reduced domestic inflationary pressure. Disadvantages: Complete loss of domestic monetary control. No lender of last resort. Loss of ability to earn seignorage from the creation of money. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc.

Currency Boards Arrangements and Dollarization Dollarization is the adoption of another nations currency as legal tender. Advantages: Elimination of domestic currency exchange rate risk.

External determination of inflation and interest rates. External macroeconomic policy discipline. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Currency Boards Arrangements and Dollarization Dollarization is the adoption of

another nations currency as legal tender. Disadvantages: Cost of replacing domestic currency with another currency. Loss of independence of monetary and exchange rate policies, facing same monetary policy as country whose currency was adopted.

Loss of central bank as lender of last resort. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Exchange Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed Floating Exchange Rate Bands Most fixed exchange rate systems allow

the rate to fluctuate within narrowly defined bands above and below par value. The actual exchange rate is determined by supply and demand within the band of fluctuation, and is prevented from moving outside band by official intervention. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Exchange Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed

Floating Adjustable Pegs An adjustable peg requires defining the par value and the band of fluctuation, with the stipulation that the currency will be devalued to correct balance of payments deficit, or revalued to correct surpluses. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Exchange Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed Floating

Crawling Pegs Under a crawling peg system, par values are changed by small preannounced amounts or percentages at frequent and clearly specified intervals until the equilibrium exchange rate is reached. This is done to avoid relatively large changes in par values and possibly destabilizing speculation. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Exchange Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed

Floating Managed Floating Under a managed floating exchange rate system, the nations monetary authorities are responsible for intervening in foreign exchange markets to smooth out short-run fluctuations without attempting to affect long-run trend in exchange rates. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Exchange Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed Floating

Managed Floating A policy of leaning against the wind requires the monetary authority to: Supply (from reserves) a portion of short-run excess demand for foreign exchange, moderating tendency of currency to depreciate. Absorb (add to reserves) a portion of any short-run excess supply, moderating tendency of currency to appreciate.

This reduces short-run fluctuations without affecting the long-run trend in Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. exchange rates. (Figure continues on next 2 slides) FIGURE 20-3 Exchange Rate Band, Adjustable Pegs, and Crawling Pegs. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc.

FIGURE 20-3 (continued) Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. FIGURE 20-3 (continued) Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. International Macroeconomic Policy Coordination Given the interdependence of nations, macroeconomic policies are more effective if coordinated. International coordination has proven

difficult because of: Lack of consensus about functioning of international monetary system. Disagreement on precise policy mix required. Disagreement on how to distribute gains from successful policy coordination among participants. Disagreement on how to spread cost of negotiating and policy Salvatore: International Economics, 11th Edition 2013 John Wiley

& Sons, Inc. agreements. Case Study 20-1 Macroeconomic Performance under Fixed and Flexible Exchange Rate Regimes Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Case Study 20-3 Macroeconomic Performance under Fixed and Flexible Exchange Rate Regimes Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc.

Case Study 20-3 Macroeconomic Performance under Fixed and Flexible Exchange Rate Regimes, continued. FIGURE 20-4 The Eurozone Countries as of the Beginning of 2012 Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Case Study 20-5 The Eurozone Crisis Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Case Study 20-6 Exchange Rate

Arrangements of IMF Members Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Appendix: Exchange Rate Arrangements Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Appendix: Exchange Rate Arrangements Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc.

Appendix: Exchange Rate Arrangements Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Appendix: Exchange Rate Arrangements Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc. Copyright 2013 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work

beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein. Salvatore: International Economics, 11th Edition 2013 John Wiley & Sons, Inc.

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