Feb Lesson 4 By John Kennes International Monetary Economics

Feb Interesting Reads about IS-LM 1.What was lost with IS-LM (2003) working paper by Roger Backhouse and David Laidler. Highly critical. 2.Macroeconomics by Burda and Wyplosz (2001), chapter 10. About money 1.Monetary Policy without Money: Hamlet without the Ghost (2003) working paper by David Laidler. Some light reading

Feb EMS –Lecture 4. Chapter 12. Optimum Currency Areas –Lecture 5. Chapter 13 EMU –Lecture 6. Chapter 14 Review –Lecture 7. Discussion of the project. any ideas in advance. Lectures on Monetary Systems

Feb What types of monetary systems are in the following regions? Europe Asia North America South America Is European Monetary Integration exportable? –Read: Barry Eichengreen (Dec 2002) Lessons of the Euro for the Rest of theWorld Monetary Systems around the world

Feb The EMS was adopted in 1979 to preserve exchange rate stability within Europe. EU members were members of EMS, ERM (Exchange Rate Mechanism) initially optional ERM members were committed jointly to defend bilateral parity if necessary by unlimited interventions and loans. Realignments required consent of all members. The European Monetary System

Feb ERM’s parity grid +/- 2.25% 2.Mutual Support Unlimited committed. Consider DK and NL. Suppose krone weak. The Dutch can produce its own currency in infinite amounts. 3.Joint Management of exchange rate realignments All members of the ERM must agree. Avoid beggar thy neighbour policies. 4.The ECU Symbolic creation of the European Currency Unit (ECU). Official unit of account: basket of currencies, weighted by size of countries, initially at parity with US dollar 4 main elements of the ERM

Feb The ECU: A basket of all EU currencies

Feb Phase 1: Inflation differed quite widely and realigments were Frequent. Phase 2: All countries decided to adopt Bundesbank’s low inflation strategy, adopting the DM as an anchor and avoiding further realignments. Phase 3: crises -> wide margins, allowed ERM to survive until launch of the euro. Phases of the EMS

Feb : EMS-1 with narrow bands of fluctuations (+/- 2.25% and symmetric : EMS-1 centered on the DM shunning realignments : EMS-1 with wide bands (+/- 15%) : EMS-2, asymmetric, on the way to the euro area The four incarnations of the EMS

Feb The three phases of the EMS

Feb Improving on the snake to stabilize intra-European exchange rates Mutual support Realignment unanimity rule Respect the EU equalitarian approach No centre currency Bilateral interventions by strong and weak currency central banks No rule for the US dollar: Europe on its own The EMS: Interpretation and Assessment

Feb The 1992 crisis provides an example of the impossible trinity. The liberalization of financial markets and the fixity of exchange rates was incompatible with divergent monetary policies, especially as Germany, the central country, was going through its unification shock. The 1992 crisis and the impossible trinity

Feb The impossible trinity principle holds that the following cannot be observed together 1.A fixed exchange rate 2.Monetary policy independence 3.Full capital mobility Many of the ERM crises can be traced backed to failed attempts at breaking this iron law. The Impossible Trinity

Feb First a flexible arrangement: Different inflation rates: long run monetary policy independence (capital controls in devaluation prone countries) Frequent realignments Evolution: From Symmetry to the DM Zone

Feb Evolution: From symmetry to the DM zone (inflation)

Feb But: realignments: Barely compensated accumulated inflation differences Were easy to guess by markets Put weak currency/high inflation countries on the spot –Continuing current account deficits –Speculative attacks The symmetry was broken de facto The Bundesbank became the example to follow Evolution: From Symmetry to the DM Zone

Feb What did shadowing the Bundesbank require? Giving up much what was left of monetary independence. Aiming at a low German-style inflation rate Avoiding realignments to gain credibility. The DM Zone

Feb Bad design –Full capital mobility established in 1990 as part of the Single Act: EMS in contradiction with impossible trinity unless all monetary independence relinquished. 2.Bad luck –German unification: a big shock that called for very tight monetary policy –The Danish referendum on the Maastricht theory 3.A wave of speculative attacks in –The Bundesbank sets limits to unlimited support Why did the DM Zone breakdown?

Feb The impossible trinity requires domestic monetary independence be abandoned if the exchange rate is rigidly fixed. Difficult when economic conditions differ (ex. Germany after reunification) If weaker currency countries impose restrictions on capital movements, speculative attacks were manageable. Once capital mobility … unlimted interventions are practically impossible. In particular, once an attack is started, defending parity implies offering the market one way bets. (i) Give up parity, speculators gain, (ii) hold parity, speculators do not lose. Monetary integration with separate currencies is risky. What are the lessons?

Feb EMS-1 ceased to exist on 1 January 1999 with the launch of the euro. EMS-2 was created to: host currencies of existing EU members who cannot/do not want to join euro area –Denmark and the UK have a derogation, but Denmark has adopted the new ERM –Sweden has no derogation but has declined to adopt the new ERM host currencies of new EU members before they are admitted into euro area –Potentially 10 new members. EMS-2

Feb EMS-1 symmetric, no anchor currency EMS-2 asymmetric, all parties defined by the euro EMS-1 margin explicitly set EMS-2 normal (+/-2.25%) and standard (+/- 15%) bands EMS-1 automatic unlimited interventions EMS-2 ECB explicitly allowed to suspend intervention How does the EMS-2 differ from the EMS-1?

Feb In principle, ERM membership is compulsory for all new members They must stay at least two years in the ERM before joining the euro area. They must also eliminate capital controls The impossible trinity says that they will have to give up monetary policy The risk of self-fulfilling crisis says that may not be enough to avoid trouble. Revival of the EMS?

Feb With the adoption of a singe currency, a new EMS was established. How does EMS-2 differ from EMS-1? The euro is now the reference currency. All EU members are required to take part in this new exchange rate mechanism unless they have a derogation, which is the case of the UK, and, defacto, of Sweden. EMS-2 remains a prerequisite for joining the euro area. 10 new members of EU are to join the mechanism as of accession. EMS-2