FLEXIBLE VERSUS FIXED EXCHANGE

RATES, EUROPEAN MONETARY

SYSTEM, AND MACROECONOMIC POLICY COORDINATION

Savatore, 2015

Patcharawan Ubonloet

19 April 2016 GSPA NIDA

OUTLINE

Fixed and Flexible exchange rates

- Pros and Cons

- Optimum currency areas

European Monetary System and

The creation of the euro and

European Central Bank

Hybrid system

- Adjustable pegs, crawling pegs and managed

floating

International macroeconomic policy

coordination 2

FIXED AND FLEXIBLE EXCHANGE RATES

Pros and Cons

Optimum currency areas

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FIXED AND FLEXIBLE EXCHANGE RATES (ER)

Fixed ER More stability to small opened economy which is

subject to large internal shocks with few trading partners

Not allowing impact on decreasing in the volume of international trade and investment leading to destabilizing speculation and inflationary

Disturbance are monetary (inflation)

Flexible ER Believe that stability of speculation is

automatically adjusted by speculators

Suitable for economy that have diversified trade and

majorly facing disturbances from real sector abroad i.e. Technology

and is subject to large external shocks i.e. Rise in export leads to

appreciation of national currency

To achieve internal and external balance

It was good for control money supply. However, it is reduced today

by international capital flow. 4

FIXED AND FLEXIBLE EXCHANGE RATES (ER)

Pros Stabilizes speculation

Minimizes international trade and investment risks

Achieve price discipline which balance of payment disequilibria is fixed (no inflation) and immediate changes in exchange rate is impossible

Requires discipline in economic management

Cons Large holding of foreign reserve

required

Fixed rates can also be devalue/revalue

Loss of internal policy (interest rates) management freedom

Pros Allowing flexible rates to find its

own equilibrium

Protects economy from other countries’ economic volatility

Minimize policy delay/mistakes in using monetary policy

Prevent gov’t from setting ER at level other than equilibrium to benefit one sector of economy on expenses of others

Cons Greater volatility

Encourages speculation

Day-to-day fluctuation discouraging specialization in production and flow of trade and investment

Fixed ER Flexible ER

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OPTIMUM CURRENCY AREAS/BLOC

Developed by Robert Mundell and Ronald Mckinnon during 1960s

A group of nations whose national currencies are linked through permanently fixed exchange rates and the conditions that would make such an area optimum. The currencies of member nations could then float jointly with respect to the currencies of nonmember nations.

In other words, geographical region in which it would maximize economic efficiency to have entire region share a single currency. 6

OPTIMUM CURRENCY AREAS/BLOC

Advantages

Eliminates the uncertainty

Stimulating specialization in

production, flow of trade and investments

Single market and benefit from greater

economies of scale in production

Greater price stability and

discourage inefficient barter deals under inflationary circumstances

Saves the cost of interventions in foreign exchange markets

Emigration of workers from poorer to richer nations

Conditions

for benefits

1. Mobility of resources

2. Structural similarity

3.Willing to coordinate

fiscal, monetary & related policy

Disadvantages

Each member nation cannot pursue

its own independent stabilization and growth policies adjusted to its particularly circumstance

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EUROPEAN MONETARY SYSTEM AND

THE CREATION OF THE EURO AND EUROPEAN CENTRAL BANK

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EUROPEAN MONETARY SYSTEM AND

THE CREATION OF THE EURO AND EUROPEAN CENTRAL BANK

European Monetary System (EMS)

Main feature of EMS

Creation of European Currency Unit (ECU) weighted average of the currencies of the member nations

Allowing the currency of each EU member to fluctuate by maximum of 2.25 percent on either side of its central rate or parity and jointly floating against the dollar

Establishment of the European Monetary Cooperation Fund (EMCF) to provide short- and medium term balance-of-payment assistance to members

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TRANSITION TO MONETARY UNION

THREE-STAGE TRANSITION

1979

1991

1999

1998

EU to form EMS

Maastricht Treaty Convergence criteria

European Central Bank (ECB)

THREE-STAGE TRANSITION 1. Convergence of economic performance

and cooperation in monetary and fiscal

policy& removal of all restrictions to capital

movement

2. Creating a European Monetary Institute

(EMI) for European Central Bank (ECB)

3. Completion of monetary union by 1999

1989

European Monetary Union (EMU) The euro (€) were trade in financial markets

and common monetary policy by ECB

After 1993 Countries converted more to ECU

Value of ECU = $1.1042

Stability and Growth Pact (SGP) Budget deficit smaller than 3% of GDP to prevent

excessive money creation, inflation and a weak euro. German couldn't’ meet the target.

1997

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MAASTRICHT TREATY

Convergence Criteria to the Monetary Union

1998,most members countries met the most of the Maastricht criteria

Price stability

Inflation rate

< 1.5% point average of the three nations with

the lowest rate

Sustainable

public finance Gov’t debt

< 60% of GDP

Durability of convergence

Long-term interest rates < 2 points more than the

average interest rates of the three countries with the lowest

inflation rates

Sound public

finance

Budget deficit

< 3% of GDP

Exchange rate stability

Average exchange rate not falling by more than

2.25% of the average of the EMS for the 2 years

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THE CREATION OF THE EURO,

EUROPEAN CENTRAL BANK AND THE COMMON MONETARY POLICY

EMU have 12 members of EU that have adopted

the euro as their common currency and have

established the ECB to conduct their common

monetary policy. Euro notes and coin became

the sole legal tender. Even though the euro

fluctuated in relation to other currencies, the

exchange rate of the participating currency

remained rigidly fixed in terms of euros as

earlier decided in 1998.

ECB

The institution similar to the Federal Reserve

System in the U.S. that would not control the

money supply and issue the single currency of

the EU. It is responsible for the common EMU

monetary policy. It aims to pursue price

stability and political free.

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ECB VERSUS FED

European Parliament

has no power to

influence ECB’s decision

to prevent excessive

monetary stimulus and

thus inflation

Maastricht Treaty can

be amended by

legislations/voters in

member countries for ECB’s statute to change

Congress can pass laws

to reduce independency of FEB board

ECB FED

Criticized for being

undemocratic and

unresponsive to

economic needs of citizens

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CURRENCY BOARD ARRANGEMENTS (CBAS) AND DOLLARIZATION

CBA is the most extreme form of a fixed exchange rate system.

Adopted when in a financial crisis and to combat inflation. i.e. Hong Kong 1983 and Argentina 1991-2001

The exchange rate arrangement whereby the nation rigidly fixes the exchange rate of its currency to a foreign currency or basket of currencies. i.e. adopting the dollars as the nation’s currency.

Its central bank loses its ability to

1) Conduct an independent monetary policy by allowing the nations supply to increase or decrease only in response to balance-of- payments surpluses or deficits.

2) Act as lender of last resort

3) Collect seignorage from issuing own currency

Dollarization is further than CBA. It is the situation whereby a nation adopts another nation’s currency as its legal tender i.e. Panama&Ecuador

Advantages are

1) Avoiding cost of own currency to dollars and hedge foreign exchange risks

2) Inflation and interest rate similar to the U.S.

3) Avoid foreign exchange crises and the need for foreign exchange and trade controls

4) Fostering budgetary discipline and promote more rapid and full international financial integration

Disadvantages

1) Cost of replacing the domestic currency with the dollar

2) Loss of monetary and exchange rate policies independency

3) Loss of central bank as a lender of last resort to bail out domestic banks in case of crisis

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HYBRID SYSTEM

Adjustable pegs, crawling pegs and managed floating

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Nations monetary authority intervene in foreign exchange markets to smooth out short-run fluctuations in exchange rates without attempting to affect their long-run trend.

The monetary authority supply, out of international reserves, a proportion of any short-run excess demand for foreign exchange in the market (thus moderating the tendency of the currency depreciation) and absorb (to add to its reserves) a portion of any short-run excess supply of foreign exchange in the market (moderating the tendency of the currency appreciation)

HYBRID SYSTEM ADJUSTABLE PEGS, CRAWLING PEGS AND MANAGED FLOATING

The system which exchange rates or par values are periodically changed to correct bop disequilibria. The band of allowed fluctuation is very narrow.

Adjustable pegs

The system under which par values or exchange rates are changed by very small preannounced amounts at frequent and clearly specified intervals until the equilibrium exchange rate is reached.

Nation set par value preventing destabilizing speculation by manipulate short-term interest rates so as to neutralize profit from scheduled change in exchange rate.

Crawling pegs

Managed floating (Dirty float)

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INTERNATIONAL

MACROECONOMIC POLICY COORDINATION

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INTERNATIONAL MACROECONOMIC POLICY COORDINATION

The modifications of national economic policies in

recognition of international interdependence.

Obstacles

Lack of consensus about the functioning of

international monetary system i.e. Whether money

expansion leads to increased output and employment

or only inflation

Lack of agreement on policy mix required

because of identifying gains from the cost of

coordination and perhaps they are not very large or it

maybe of that inability to capture full benefits. 18

THANK YOU

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