dale r. deboer university of colorado, colorado springs 15 - 1 an introduction to international...
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Dale R. DeBoerUniversity of Colorado, Colorado Springs
15 - 1
An Introduction to International Economics
Chapter 15: Flexible versus Fixed Exchange Rates, European Monetary
System, and Macroeconomic Policy Coordination
Dominick SalvatoreJohn Wiley & Sons, Inc.
15 - 2Dale R. DeBoerUniversity of Colorado, Colorado Springs
Flexible vs. fixed exchange rates
• The advantages of flexible exchange rates– External disequilibria are automatically corrected
by exchange rate movements.
15 - 3Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 4Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 5Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 6Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 7Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 8Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
15 - 9Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 10Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 11Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 12Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 13Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 14Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 15Dale R. DeBoerUniversity of Colorado, Colorado Springs
Steps to European monetary union
• The European Monetary System
• The Maastricht Treaty
• European Monetary Union
15 - 16Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
15 - 17Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 18Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 19Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 20Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
15 - 21Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
15 - 22Dale R. DeBoerUniversity of Colorado, Colorado Springs
The Maastricht Treaty
• The Maastricht Treaty, 1991, generated the agenda by which full monetary union would be achieved.
15 - 23Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 24Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 25Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 26Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 27Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 28Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 29Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 30Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 31Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
15 - 32Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
15 - 33Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 34Dale R. DeBoerUniversity of Colorado, Colorado Springs
Currency boards
• A currency board arrangement rigidly fixes the value of a nation’s currency to that of a foreign currency.
15 - 35Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 36Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 37Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 38Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 39Dale R. DeBoerUniversity of Colorado, Colorado Springs
Dollarization
• Dollarization is the adoption of another nation’s currency as legal tender.– This is an extreme form of a currency board.
15 - 40Dale R. DeBoerUniversity of Colorado, Colorado Springs
Dollarization
• Dollarization is the adoption of another nation’s currency as legal tender.
• Advantages– Elimination of domestic currency exchange rate
risk
15 - 41Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 42Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 43Dale R. DeBoerUniversity of Colorado, Colorado Springs
Dollarization
• Dollarization is the adoption of another nation’s currency as legal tender.
• Advantages
• Disadvantages– Loss of policy independence
15 - 44Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 45Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
15 - 46Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
15 - 47Dale R. DeBoerUniversity of Colorado, Colorado Springs
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 long-term trend value.
15 - 48Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
15 - 49Dale R. DeBoerUniversity of Colorado, Colorado Springs
International macroeconomic policy coordination
• Given the interdependence of nations, macroeconomic policies will be more successful if coordinated.
• International coordination has proven difficult.