Exchange Rate Regimes and the Euro MBA W7 Professor Dermot McAleese

EXCHANGE RATE AND BUSINESS Business is affected by:  The level of exchange rate  The exchange rate regime  The methods of defending the regime  Currency instability

OUTLINE  The global exchange rate system  Floating exchange rate in theory and practice  Search for stability  EMU and the introduction of euro  Conclusions

EXCHANGE RATE ARRANGEMENTS End-1984 : 148 countries Source: IMF International Financial Statistics

EXCHANGE RATE ARRANGEMENTS Source: IMF International Financial Statistics End : 184 countries

FEATURES OF THE PRESENT GLOBAL EXCHANGE RATE SYSEM  The word’s 3 major currencies, the US$, the yen and the euro are ‘independently floating’  A growing number of countries have adopted a flexible exchange rate regime  Yet 38% of currencies still linked at a fixed rate (‘pegged’) to another currency or basket of currencies and 14% more are ‘managed float’  Although countries with pegged currencies are numerous, their combined economic weight in world trade is modest  Movement towards ‘more extreme’ exchange rate regimes

“There are no major difficulties to prevent the prompt establishment by countries of a system of exchange rates freely determined in open markets, primarily by private transactions, and the simultaneous abandonment of direct controls over exchange transactions. A move in this direction is the fundamental prerequisite for the economic integration of the free world through multilateral trade.” Milton Friedman, 1956

CHANGES IN THE EXCHANGE RATE AND PAYMENTS IMBALANCES S0S0 D1D1 D1D1 D0D0 D0D0 Q1Q1 Q0Q0 Q* E* E0E0 Amount of Foreign Exchange Exchange rate (domestic currency per unit of foreign currency)

EXCHANGE RATE DETERMINANTS  Supply of forex  Demand for forex  Equilibrium exchange rate  Direct and indirect effects of  ER  Balance of payment deficit/surplus  Changes in ER over time

FLOATING EXCHANGE RATE  Advantages:  Increased autonomy in monetary policy  Low foreign reserves requirements  No more balance of payment and ER ‘crises’  Disadvantages:  Volatility inhibits trade and investment  Destabilising speculation exacerbates the problem  Domestic stabilisation measures can be undermined

SEARCH FOR STABILITY Two ways to obtain stability: Pegging to an anchor currency (Ecuador, Baltic States, Hong Kong, French West Africa)  A single currency (the euro) (Because of time constraints we focus on the euro.)

THEORY OF OPTIMUM CURRENCY AREAS STRESSES:  Labour mobility  Wage and price flexibility  Counter-cyclical fiscal transfers  Trade and investment links  Proneness to asymmetric shocks  Credibility of link A SINGLE CURRENCY

LEAD INDICATORS OF EXCHANGE RATE CRISES  Overheating  Inflation  Current account deficit  Domestic credit expansion  Asset prices

MEASURES TO INFLUENCE THE EXCHANGE RATE (1) Direct intervention in the forex market (2) The interest rate (3) Throwing sand in the wheels of the forex market (4) Enhanced international co-ordination of economic policy (5) Ministerial and government statements

EUROPEAN MONETARY UNION  Efficiency gains  Transaction costs  Exchange rate uncertainty  Transparency of prices  Enhanced role of EU in the international monetary system  Costs  Incidence of ‘asymmetric shocks’ - difference in production structure of economy - extent of trade and investment - degree of factor mobility - wages and prices flexibility - degree of fiscal integration  Transition costs

 On-going debate  Inappropriate monetary policy – one size fits all  Enlargement of membership  Stability and Growth Pact (too restrictive fiscal targets)

BACKGROUND TO EMU  1970: Werner Report  1979: European Monetary System  1989: Delors Report  1991: Maastricht Treaty  1996: Stability and Growth Pact  1998: European Central Bank  1999: Single currency  2002: Euro in circulation

FINAL COMMENTS: EXAMS DE-BRIEFING