1. Lecture Monetary Unions
Prof. Stefano Bolatto
May 23rd, 2018

2. Fixed exchange rates
Maintaining fixed exchange rates in the long-run requires strict controls over capital movements
Moreover, attempts to fix exchange rates are likely to relatively short-lived because of currency attacks
Speculation against one currency is most likely to occur under a fixed exchange rate regime, when the central bank is committed to keeping the value of the currency at a given level
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3. Self-fulfilling currency crisis
If potential gains are large compared to potential losses, a lot of speculators will be willing to bet on the currency devaluation: this will result in a massive capital outflow
If the central bank have a limited amount of official reserves to defend the peg, devaluation will occur anyway
What is crucial is not the real economic conditions of the country whose currency is under attack, but the expectations of the speculators!
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4. Inflation as a self-fulfilling prophecy
Another example of self-fulfilling prophecy, in economics, is represented by high inflation (i.e. a sustained increase in the general price level), that can be due to:
Excessive money supply
Excess level of economic activity (over employment)
Expectations of inflation
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5. Expected and actual inflation
Labor market equilibrium requires that workers are rewarded according to their marginal productivity
Real wage (= W/P) = labor productivity
If this condition is verified, no voluntary unemployment
Consider negotiations between labor unions and employers’ associations for setting the level of nominal wages (W) in contracts to be applied in the future years
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6. Both parts agree on maintaining real wage in line with labor productivity
This means that, if both the part expect higher inflation in the future, they will agree to set higher nominal wages (to the same extent of the anticipated increase in prices)
For a given price level, higher nominal wages will induce an excess demand, thereby generate inflation (just like an excess money supply)
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7. First best option
Now suppose that, for some reason, real wages are too high, as they exceed the equilibrium level:
W/P > MLP
This result in unemployment. Policy-makers want to solve the problem, restoring labor market equilibrium
The first best option would be reducing nominal wage: this requires labor unions and the counterpart agree to sign a new contract, with a lower nominal wage
Is it doable?
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8. Trade-off between inflation and unemployment
Second best option
Second best option: without any need to get an agreement, policy-makers can unilaterally achieve their goal (restoring the equilibrium) by generating inflation
↑ P ⇒ ↓ W/P
Nominal wages do not change, but the increase in price brings real wage back to the equilibrium level (= MLP)
Trade-off between inflation and unemployment
Second best: inflation has negative externalities!
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9. Surprise inflation
However, this attempt of the policy-makers can be frustrated if private agents will anticipate this policy (they will expect inflation and rise nominal wages, so that W/P will not change)
In other words, if they want to achieve their goal, policy-maker have to generate surprise inflation, that is, an inflation higher than what expected by economic agents
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10. If the actual inflation is 5%, real wages stay unchanged
A simple example
Suppose that the expected inflation rate is 5%, so that trade unions will rise nominal wages by 5%
If the actual inflation is 5%, real wages stay unchanged
If the actual inflation rate is 7%, real wages decline
If policymakers have a strong incentive to generate surprise inflation for solving economic disequilibria, they are said to have temptation of inflation, which may give rise to a severe problem of credibility
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11. Same story, different case
Temptation of inflation even in case of high cost of servicing debt…
First best policy: reducing the level of public debt (more taxes, reduction in public spending)
Second best policy: generating surprise inflation
Suppose that economic agents are willing to subscribe government bonds if the letter offer a real return = 5%
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12. If economic agents expect 2% inflation over the period of bond maturity, nominal interest rates will be then set at 7% (so that 7% - 2% = 5%)
If the central bank generate surprise inflation, say 4% instead of the expected 2%, the ex-post real exchange rate will be 7% - 4% = 3%
Ex-post real return lower than the ex-ante: the government save some resources, but investors have been “cheated”.. So what happens at the next round?
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13. If economic agents expect 2% inflation over the period of bond maturity, nominal interest rates will be then set at 7% (so that 7% - 2% = 5%)
If the central bank generate surprise inflation, say 4% instead of the expected 2%, the ex-post real exchange rate will be 7% - 4% = 3%
Ex-post real return lower than the ex-ante: the government save some resources, but investors have been “cheated”.. So what happens at the next round?
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14. At the next round… investors will expect 4% inflation, so that they will subscribe government bonds only if nominal interest rates are set at 5% + 4% = 9%
If the central bank is up to its old tricks, this time it will have to generate a surprise inflation, of 5%, or 6%, or more, and so on..
The economy ends up having very high inflation, high debt, and problems in borrowing internationally (how long are investors willing to keep on being cheated?)
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15. At the next round… investors will expect 4% inflation, so that they will subscribe government bonds only if nominal interest rates are set at 5% + 4% = 9%
If the central bank is up to its old tricks, this time it will have to generate a surprise inflation, of 5%, or 6%, or more, and so on..
The economy ends up having very high inflation, high debt, and problems in borrowing internationally (how long are investors willing to keep on being cheated?)
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16. Lack of credibility
If economic authorities are not credible, any announcement about the economic policy will be misbelieved by economic agents, and expectations will not be formed in a correct way
This can lead to an high sacrifice ratio, when implementing stabilizing macroeconomic policies
Consider an economy with high inflation, that must be necessarily reduced to avoid any further inconvenient
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17. Case of credible institutions
The central bank announces its intention to reduce inflation by means of a restrictive monetary policy
If the central bank is credible, its announcement is fully believed by economic agents and the expected inflation rate (for the future period) will be lower
The simple expectation of a future lower inflation can be sufficient to actually reduce the inflation rate for the next period
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18. Its simple announcement is enough!
The mechanism works at the opposite than before: since everybody expect low inflation or no inflation, they will rise nominal wages and prices to a very limited extent
The goal of the policymakers is achieved even without actually implementing the announced restrictive policy
Its simple announcement is enough!
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19. Case of non credible institutions
If the central bank is not credible, its announcement is not believed by economic agents and the expected inflation rate (for the future period) will stay high
To actually lower inflation rates, the central bank will be forced to actually implement (perhaps in an ever tighter way) the announced restrictive monetary policy
Reduction in money supply is restrictive: it reduces the level of income and production (unemployment rises)
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20. Time inconsistency
Lack of credibility of policy authorities can be a major issue: in case of disinflationary policies (or any other stabilizing intervention), it implies a high sacrifice ratio
The latter is the % decline in the GDP that is required to reduce the inflation rate by one percentage point
If affected by temptation of inflation, central banks will systematically implement a policy different from that announced, incurring in a lack-of-credibility problem
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21. monetary policy is devoted to defend currency peg
Fixed exchange rates
A possible solution to the central bank’s credibility problem is adopting a fixed exchange rate regime, so that the central bank is constrained from using monetary policy to control the economy
monetary policy is devoted to defend currency peg
As economic agents do not trust the central bank and the credibility problem cannot be solved, the central bank may prefer to give up with its autonomy, abdicating the possibility to use monetary policy
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22. Yet, this is not an ultimate solution: at any point in time, the central bank can devaluate the currency, without any particular technical impediment
The systematic use of devaluation is equivalent to the use of a discretionary monetary policy (reiterating the same credibility problem of the central bank)
A more effective solution? Giving up with the local currency and adopt the same currency of another country with no credibility problems (anchor currency)
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23. Dollarization (Ecuador, 2000) Eurization (Montenegro, 2002)
Currency substitution is more effective as a solution for the central bank’s credibility problem, because:
it rules out the possibility of devaluating
the way back is much more cumbersome: restoring national currency is costly and implies a lot of technical issues
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24. OK if the country with credibility problems is small enough
Yet, currency substitution works if the monetary policy of the country with the anchor currency is completely unaffected by the presence of another nation that uses the same currency
OK if the country with credibility problems is small enough
What if the country with credibility problems is a big one?
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25. Monetary unions
For bigger countries, currency substitution takes the form of a monetary union
A monetary union involves two or more states that share the same currency (without necessarily having any further integration) and set up institutional arrangements in which they jointly decide on monetary policy
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26. If a given country is part of a monetary union, albeit its monetary authorities lack commitment (i.e. are not credible), they are unable to engineer surprise inflation
The union-wide authority reacts only to union-wide shock, and its inability to react to country-specific shocks results in a lower price volatility in each country
Entering a monetary union is essentially a commitment device to less variable undesirable inflation when central banks have temptation of inflation
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27. …and the better this sort of insurance scheme works!
By joining a monetary union, countries makes mutual insurance against the possibility of country-specific shocks, given the lack of commitment of their central banks
In this regard, the more heterogeneous the economies of the states joining the monetary union, the more country-specific the shocks…
…and the better this sort of insurance scheme works!
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28. Open questions:
This theory assumes that, ex-ante, all countries forming the union have the same probability to be hit by a shock. What if we assume different ex-ante probabilities?
France and Italy (affected by credibility problems) exerted lot of political pressure to have a European monetary union.. While did Germany (not affected) finally agree? The answer has more to do with politics..
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