The international monetary system

Chapter 34 The international monetary system David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 34.1 Key issues  Exchange rate regimes and their implications for the world economy  Possibilities of policy co-ordination  Policy co-ordination in Europe 34.2 Exchange rate regimes Exchange rate Forex intervention Fixed Floating Free float None Gold standard currency board Automatic Adjustable peg Managed float Some discretion 34.3 The gold standard  Characteristics of the gold standard: – The government of each country fixes the price of gold in terms of its domestic currency. – The government maintains convertibility of domestic currency into gold. – Domestic money creation is tied to the government's holding of gold.  Adjustment to full employment is via domestic wages and prices – creating vulnerability to long and deep recessions. 34.4 The adjustable peg and the dollar standard  In an adjustable peg regime, exchange rates are normally fixed, but countries are occasionally allowed to alter their exchange rate.  Under the Bretton Woods system, each country announced a par value for their currency in terms of US dollars – the dollar standard. 34.5 The dollar standard  Faced with a balance of payments deficit under the dollar standard  countries could try to avoid monetary contraction by running down foreign exchange reserves  but devaluation could not be postponed for ever, given finite reserves  expansion of US money supply began to spread inflation world-wide 34.6 Floating exchange rates  Under pure/clean floating, forex markets are in continuous equilibrium  the exchange rate adjusts to maintain competitiveness  but in the short run, the level of floating exchange rates is determined by speculation – given that capital flows respond to interest rate differentials. 34.7 Fixed versus floating exchange rates  Robustness – Bretton Woods system was abandoned because it could not cope with real and nominal strains – a flexible rate system is probably more robust  Volatility – fixed rate system offers fundamental stability – flexible rate system is potentially volatile – but instability must be accommodated in other ways under a fixed rate system  Financial discipline – fixed rate system imposes discipline and policy harmonization. 34.8 International policy co-ordination  Can a concerted attempt by a group of countries to co-ordinate their policy bring benefits to the group?  Externality argument: – non-co-operative policy can impose costs that can be avoided by agreement between governments  Reputation argument – co-ordination may allow individual governments to pre-commit to policies that would otherwise not be credible 34.9 The European Monetary System  Established by members of the European Community (including the UK) in 1979  A system of monetary and exchange rate co-operation.  Included the Exchange Rate Mechanism (ERM) – which the UK did not join until 1990 – and it left again in 1992.  The system had some success in reducing exchange rate volatility – through co-ordination of monetary policy – plus exchange rate controls – even if it did not work for the UK. 34.10 Chapter 35 European integration David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 35.12 Some key issues  The European Single Market – what difference did it make?  Economic and Monetary Union (EMU) – why did it happen? – What difference will it make?  Reform in Eastern Europe – how are these countries faring in their transition from central planning to market economies? 35.13 The Single Market  Established under the Single European Act of 1987  with December 1992 as the target date for completion – which was met 0 1000 2000 3000 4000 5000 6000 EU USA Japan b il li o n s o f E C U s 0 50 100 150 200 250 300 350 400 m il li o n s GDP (LH scale) Population (RH scale) 35.14 Objectives of the Single Market  Abolition of remaining foreign exchange controls on capital flows  removal of non-tariff barriers within the EU  elimination of bias in public sector provisioning  removal of frontier controls – with some provisos  progress towards harmonization of tax rates 35.15 Benefits of the Single Market  Improved resource allocation – removal of non-tariff barriers allows more exploitation of comparative advantage  Scale economies – larger potential market increases the scope for economies of scale  Intensified competition – may stimulate greater cost efficiency  Factor mobility – enables greater efficiency through mobility of labour and capital 35.16 Gains from the Single Market 0 5 10 15 20 25 % of in iti al GD P Low 2 2 3 4 4 5 19 High 3 5 4 5 10 16 20 F, D, I, UK Den NL, Sp B,Lux Ire Gr Port Source: Allen, Gasiorek and Smith (1998) 35.17 From EMS to EMU  A monetary union has – permanently fixed exchange rates within the union – an integrated financial market – a single central bank setting the single interest rate for the union.  The Maastricht Treaty set criteria for EMU entry – to define ‘convergence’  The single currency area began in January 1999 with 11 member countries. 35.18 The Maastricht criteria  Inflation rate – no more than 1.5% above the average of the inflation rate of the lowest 3 countries in the EMS  Long-term interest rate – no more than 2% above the average of the lowest 3 EMS countries  Exchange rate – in the narrow band of ERM for 2 years  Budget deficit – no larger than 3% of GDP  National debt – no greater than 60% of GDP 35.19 Sterling and Europe 0 10 20 30 40 50 60 % of UK trade E U N or th A m er ic a R es t o f w or ld UK trade patterns 1972 1998 UK membership of ERM/EMU? North Sea oil made the UK different The UK is less integrated with the rest of Europe – but this is changing ... The UK has a greater tradition of macroeconomic sovereignty. Black Wednesday and the ERM crisis The UK’s business cycle was out of phase with the rest of Europe. 35.20 The economics of EMU  Optimal currency area – a group of countries better off with a common currency than keeping separate national currencies  3 key attributes (Mundell) – countries that trade a lot with each other – countries with similar economic and industrial structures – flexibility in labour markets 35.21 So is Europe an optimal currency area?  Europe is ‘quite’ but not very closely integrated  Some countries are more closely integrated than others  but the act of joining may itself feed the process of integration 35.22 Macroeconomic policy for a small member of Euroland IS0 LM r0 Y0 A small Euroland member faces a horizontal LM curve, given that interest rates are fixed by the ECB. If the country is too small to influence the ECB to alter interest rates, either the country must wait for wage & prices to shift IS back via improved competitiveness, Y1 IS1 Suppose an external shock moves the IS curve to IS1 or fiscal policy will be required to enable more rapid adjustment. 35.23 Central and Eastern Europe 0 5000 10000 15000 20000 US$ E Ge r Czec h. Hun Bulg Pol Rom EC W G er Port GDP per capita in 1988/89 35.24 Eastern Europe: some key issues  On the eve of transition – low per capita income – high international debt  Supply-side reforms – crucial for prices to reflect true scarcity  Trade and foreign investment – markets needed for products – and physical capital/management skills  Macroeconomic conditions – firm and credible macro policy needed – especially to avoid excessive inflation. 35.25 A progress report on the transition-15 -10 -5 0 5 10 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 % p .a . Hungary Poland Romania Bulgaria 0 100 200 300 400 500 600 700 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 % p .a . Hungary Poland Romania Bulgaria Inflation Growth of real GDP