Dale R. DeBoer University of Colorado, Colorado Springs 15 - 1 An Introduction to International...

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.



• The advantages of flexible exchange rates– External disequilibria are automatically corrected by

exchange rate movements.– Avoid mistaken or distortionary government

determination of exchange rates





determination of exchange rates– Are more efficient since resources are not

required to manage the exchange rate system





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



• The advantages of flexible exchange rates

• The advantages of fixed exchange rates– Encourage greater international trade by reducing

exchange rate risk



• 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


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





member nations– Similar national structures





member nations– Similar national structures– Willingness of the nations to coordinate policies




• Conditions

• Advantages– Elimination of exchange rate risk




• Conditions

• Advantages– Elimination of exchange rate risk– Greater price stability




• Conditions

• Advantages

• Disadvantage– The loss of ability to pursue independent policies


Steps to European monetary union

• The European Monetary System

• The Maastricht Treaty

• European Monetary Union


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




• Main features– Established the European Currency Unit (ECU)– Established narrow bounds for fluctuation (+/-

2.25 percent) around established central exchange rates




• 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




• Main features

• Between 1979 and 1992, 11 currency value realignments were needed.




• Main features

• Between 1979 and 1992, 11 currency value realignments were needed.

• In 1993, the fluctuation bounds were increased to +/- 15 percent.


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





nations and coordination of macroeconomic policies– Creation of the European Monetary Institute as a

forerunner to the European Central Bank





nations and coordination of macroeconomic policies– Creation of the European Monetary Institute as a

forerunner to the European Central Bank– Elimination of domestic currencies




• 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





• 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






– A budget deficit no greater than 3 percent of GDP– Overall government debt no greater than 60

percent of GDP






– 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



• 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


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.



• 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.



• 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


Currency boards

• A currency board arrangement rigidly fixes the value of a nation’s currency to that of a foreign currency.


Currency boards


• Advantages– Reduction in exchange rate risk


Currency boards


• Advantages– Reduction in exchange rate risk– Foreign control over the rate of monetary growth

reduces domestic inflationary pressures


Currency boards


• Advantages

• Disadvantages– Complete loss of domestic monetary control


Currency boards


• Advantages

• Disadvantages– Complete loss of domestic monetary control– Loss of ability to seignorage from the creation of

money


Dollarization

• Dollarization is the adoption of another nation’s currency as legal tender.– This is an extreme form of a currency board.


Dollarization

• Dollarization is the adoption of another nation’s currency as legal tender.

• Advantages– Elimination of domestic currency exchange rate

risk


Dollarization


• Advantages– Elimination of domestic currency exchange rate risk– External determination of inflation and interest

rates


Dollarization


• Advantages– Elimination of domestic currency exchange rate risk– External determination of inflation and interest rates– External macroeconomic policy discipline


Dollarization


• Advantages

• Disadvantages– Loss of policy independence


Dollarization


• Advantages

• Disadvantages– Loss of policy independence– Cost of obtaining the foreign currency to act as

legal tender


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.



• Adjustable peg

• Crawling peg – A system whereby adjustments to the par

currency value are made in small, pre-announced increments to prevent destabilizing speculation.



• 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.


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


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 - 1 An Introduction to International...

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