Dale R. DeBoer University of Colorado, Colorado Springs An Introduction to International Economics Chapter 15: Flexible versus Fixed Exchange Rates, European Monetary System, and Macroeconomic Policy Coordination Dominick Salvatore John Wiley & Sons, Inc.

Dale R. DeBoer University of Colorado, Colorado Springs Flexible vs. fixed exchange rates The advantages of flexible exchange rates –External disequilibria are automatically corrected by exchange rate movements.

Dale R. DeBoer University of Colorado, Colorado Springs Flexible vs. fixed exchange rates The advantages of flexible exchange rates –External disequilibria are automatically corrected by exchange rate movements. –Avoid mistaken or distortionary government determination of exchange rates

Dale R. DeBoer University of Colorado, Colorado Springs Flexible vs. fixed exchange rates The advantages of flexible exchange rates –External disequilibria are automatically corrected by exchange rate movements. –Avoid mistaken or distortionary government determination of exchange rates –Are more efficient since resources are not required to manage the exchange rate system

Dale R. DeBoer University of Colorado, Colorado Springs Flexible vs. fixed exchange rates The advantages of flexible exchange rates –External disequilibria are automatically corrected by exchange rate movements. –Avoid mistaken or distortionary government 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

Dale R. DeBoer University of Colorado, Colorado Springs Flexible vs. fixed exchange rates The advantages of flexible exchange rates The advantages of fixed exchange rates –Encourage greater international trade by reducing exchange rate risk

Dale R. DeBoer University of Colorado, Colorado Springs Flexible vs. fixed exchange rates 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

Dale R. DeBoer University of Colorado, Colorado Springs 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.

Dale R. DeBoer University of Colorado, Colorado Springs 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

Dale R. DeBoer University of Colorado, Colorado Springs 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 –Similar national structures

Dale R. DeBoer University of Colorado, Colorado Springs 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 –Similar national structures –Willingness of the nations to coordinate policies

Dale R. DeBoer University of Colorado, Colorado Springs 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 Advantages –Elimination of exchange rate risk

Dale R. DeBoer University of Colorado, Colorado Springs 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 Advantages –Elimination of exchange rate risk –Greater price stability

Dale R. DeBoer University of Colorado, Colorado Springs 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 Advantages Disadvantage –The loss of ability to pursue independent policies

Dale R. DeBoer University of Colorado, Colorado Springs Steps to European monetary union The European Monetary System The Maastricht Treaty European Monetary Union

Dale R. DeBoer University of Colorado, Colorado Springs 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.

Dale R. DeBoer University of Colorado, Colorado Springs 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

Dale R. DeBoer University of Colorado, Colorado Springs 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) –Established narrow bounds for fluctuation (+/ percent) around established central exchange rates

Dale R. DeBoer University of Colorado, Colorado Springs 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) –Established narrow bounds for fluctuation (+/ percent) around established central exchange rates –Established the European Monetary Cooperation Fund

Dale R. DeBoer University of Colorado, Colorado Springs 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 Between 1979 and 1992, 11 currency value realignments were needed.

Dale R. DeBoer University of Colorado, Colorado Springs 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 Between 1979 and 1992, 11 currency value realignments were needed. In 1993, the fluctuation bounds were increased to +/- 15 percent.

Dale R. DeBoer University of Colorado, Colorado Springs The Maastricht Treaty The Maastricht Treaty, 1991, generated the agenda by which full monetary union would be achieved.

Dale R. DeBoer University of Colorado, Colorado Springs 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

Dale R. DeBoer University of Colorado, Colorado Springs 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 –Creation of the European Monetary Institute as a forerunner to the European Central Bank

Dale R. DeBoer University of Colorado, Colorado Springs 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 –Creation of the European Monetary Institute as a forerunner to the European Central Bank –Elimination of domestic currencies

Dale R. DeBoer University of Colorado, Colorado Springs The Maastricht Treaty The Maastricht Treaty, 1991, generated the agenda by which full monetary union would be achieved. 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

Dale R. DeBoer University of Colorado, Colorado Springs The Maastricht Treaty The Maastricht Treaty, 1991, generated the agenda by which full monetary union would be achieved. 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 –A budget deficit no greater than 3 percent of GDP

Dale R. DeBoer University of Colorado, Colorado Springs The Maastricht Treaty 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 –A budget deficit no greater than 3 percent of GDP –Overall government debt no greater than 60 percent of GDP

Dale R. DeBoer University of Colorado, Colorado Springs The Maastricht Treaty 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 –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

Dale R. DeBoer University of Colorado, Colorado Springs The Maastricht Treaty 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

Dale R. DeBoer University of Colorado, Colorado Springs The European Monetary Union In 1999, the EMS became the European Monetary Union. –Electronic trading of the euro (€) began in –Euro notes and coins were introduced in 2002.

Dale R. DeBoer University of Colorado, Colorado Springs The European Monetary Union 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.

Dale R. DeBoer University of Colorado, Colorado Springs The European Monetary Union 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 linkWWW link

Dale R. DeBoer University of Colorado, Colorado Springs Currency boards A currency board arrangement rigidly fixes the value of a nation’s currency to that of a foreign currency.

Dale R. DeBoer University of Colorado, Colorado Springs Currency boards A currency board arrangement rigidly fixes the value of a nation’s currency to that of a foreign currency. Advantages –Reduction in exchange rate risk

Dale R. DeBoer University of Colorado, Colorado Springs Currency boards A currency board arrangement rigidly fixes the value of a nation’s currency to that of a foreign currency. Advantages –Reduction in exchange rate risk –Foreign control over the rate of monetary growth reduces domestic inflationary pressures

Dale R. DeBoer University of Colorado, Colorado Springs Currency boards A currency board arrangement rigidly fixes the value of a nation’s currency to that of a foreign currency. Advantages Disadvantages –Complete loss of domestic monetary control

Dale R. DeBoer University of Colorado, Colorado Springs Currency boards A currency board arrangement rigidly fixes the value of a nation’s currency to that of a foreign currency. Advantages Disadvantages –Complete loss of domestic monetary control –Loss of ability to seignorage from the creation of money

Dale R. DeBoer University of Colorado, Colorado Springs Dollarization Dollarization is the adoption of another nation’s currency as legal tender. –This is an extreme form of a currency board.

Dale R. DeBoer University of Colorado, Colorado Springs Dollarization Dollarization is the adoption of another nation’s currency as legal tender. Advantages –Elimination of domestic currency exchange rate risk

Dale R. DeBoer University of Colorado, Colorado Springs Dollarization Dollarization is the adoption of another nation’s currency as legal tender. Advantages –Elimination of domestic currency exchange rate risk –External determination of inflation and interest rates

Dale R. DeBoer University of Colorado, Colorado Springs Dollarization Dollarization is the adoption of another nation’s currency as legal tender. Advantages –Elimination of domestic currency exchange rate risk –External determination of inflation and interest rates –External macroeconomic policy discipline

Dale R. DeBoer University of Colorado, Colorado Springs Dollarization Dollarization is the adoption of another nation’s currency as legal tender. Advantages Disadvantages –Loss of policy independence

Dale R. DeBoer University of Colorado, Colorado Springs Dollarization Dollarization is the adoption of another nation’s currency as legal tender. Advantages Disadvantages –Loss of policy independence –Cost of obtaining the foreign currency to act as legal tender

Dale R. DeBoer University of Colorado, Colorado Springs 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.

Dale R. DeBoer University of Colorado, Colorado Springs Other exchange rate systems Adjustable peg Crawling peg –A system whereby adjustments to the par currency value are made in small, pre-announced increments to prevent destabilizing speculation.

Dale R. DeBoer University of Colorado, Colorado Springs Other exchange rate systems 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.

Dale R. DeBoer University of Colorado, Colorado Springs 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 SummitWWW link

Dale R. DeBoer University of Colorado, Colorado Springs International macroeconomic policy coordination Given the interdependence of nations, macroeconomic policies will be more successful if coordinated. International coordination has proven difficult.