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Theorie und Politik der Europäischen Integration
Prof. Dr. Herbert Brücker
Lecture 6
A Monetary History of Europe Choice of Exchange Rate Systems
Theory and Politics of Eropean Integration
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Last Lecture
• Growth effects, capital and labour market integration• Growth effects
· Static and dynamic effects of integration· Static: allocation effects· Neoclassical (Solow) growth model: temporary growth effects,
in steady state higher income level· Endogenous growth models: continuous growth effects via
higher investment in physical and human (knowledge) capital which increases rate of technological progress
· Empirical evidence: higher transitional growth through integration
• Capital market integration· Integration equalises capital endowments and interest rates· Creates winners and loses in sending and receiving countries· Aggregate income gain
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Last Lecture
• Labour market integration· Institutions· Scale of migration and income differences· Composition of migrants, self-selection and out-selection· Labour market impact
– Standard model with perfect labour markets– Equalisation of wage rates– Aggregate gains, but winners and losers– More complex models:– Capital stock adjustment– Wage rigidities and unemployment– Empirical evidence
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
This lecture: Monetary Integration I
• A monetary history of Europe• Metallic money• The gold standard• The interwar period• The post-wa<r period: from Bretton Woods to EMU
• Choice of an exchange rate regime• Exchange rate and monetary policy• The range of exchange rate policies• Choices
· Criteria· Fix or float?· Regional arrangements
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Why studying history?
• Monetary union is the controversial end of a long process. History helps understand.
• Since paper money was invented, Europe’s monetary history carries important lessons. Particularly the bad ones.
• Before paper money, Europe was a de facto monetary union. Understand how it worked helps understand how the new union (EMU) works.
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Metallic Money
• Under metallic money (overlooking the difference between gold and silver) the whole world was really a monetary union
• Seignorage as key source of public finance· ‘shaving’ as a means to generate revenues
• Multiplicity of money• Previous explicit unions only agreed on the metal content
of coins to simplify everyday trading
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Metallic Money: Some Details
• From immemorial until 19th century metallic money (gold or silver) dominant means of payment
• Bimetallism (gold and silver) with fluctuating exchange rates depending on discoveries
• Monetary unions as a tool of nation-building• e.g. Germany: before 1871 different monetary standards
• Two historical monetary unions• Latin Monetary Union (BE, FR, IT) to preserve bimetallism• Scandinavian Monetary Union ceased at WWI
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Gold standard
• Classic gold standard period 1880-1914• Frequent financial crises, armed conflicts and depressions• Working of the gold standard: Hume’s “price-specie-
mechanism”• (“specie” = money/gold)
• Key assumptions or macroeconomic principles• long-run neutrality of money
· rate of inflation is driven by rate of money growth
• effect of money on interest rates• Helps to understand working of EMU
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Neutrality of money and current account equilibrium
gold money
price level
P1
M1 M0
A
current account deficit
current account surplus
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Neutrality of money and current account equilbrium
gold money
price level
P1
M1 M0
A
current account deficit
current account surplus
Money determines the price level (in the long run)
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Neutrality of money and current account equilbrium
gold money
price level
P*
M1 M0
A
current account deficit
current account surplus
Price level affects the trade balance• If domestic prices are
high relative to foreign prices, we have a deficit
• Conversely, relatively low domestic prices lead
to a trade surplus
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Neutrality of money and current account equilbrium
gold money
price level
P1
M1 M0
A
current account deficit
current account surplus
Trade balance is achieved when the stock of money is M1, and, hence, domestic prices equal P*.
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Balance of payment equilibrium
gold money0
M0
AC B‘ B
outflow of moneyinflow of money
BoP
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Balance of payment equilbrium
gold money0
M0
A
C
B‘ B
outflow of moneyinflow of money
Hume’s mechanism: return to balance is automatic.• If we start with a high money stock (e.g. point B), domestic prices are high, balance of payments turns in deficit and gold flows out, but commodities in (current account surplus)• Why? We have to buy other goods by gold.
BoP
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Balance of payment equilbrium
gold money0
M0
AC
B‘
B
outflow of moneyinflow of money
• If we start with a low money stock (e.g. point C), balance of payments turns in surplus and gold flows in,• but commodities out (current account deficit)
Point A correesponds to price level P* and money supply M1 in first graph, where current account is in equilbrium
BoP
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Financial account equilibrium
gold money
interest rate
i*
M2M0
A
financial account surplusfinancial account deficit
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Financial account equilibrium
gold money
interest rate
i*
M2M0
A
financial account surplusfinancial account deficit
Much the same story applies to the financial account: • if the stock of money increases, the domestic interest rate declines• if the interest rate is below the international rate i*, it pays to borrow gold at home and ship it abroad, i.e. capital flows out
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Financial account equilibrium
gold money
interest rate
i*
M2M0
A
financial account surplusfinancial account deficit
Thus, if i > i*, capital account is in surplus, and if i < i* it turns into a deficit• Equilibrium is achieved if i = i*
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Financial account equilibrium
gold money
interest rate
i*
M2M0
A
financial account surplusfinancial account deficit
Relation between financial and current account:• Capital inflow increases interest rate and prices•Both capital and current account deteriorate•Trade route is slower, but both work in same direction
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Monetary equilibrium under gold standard
• Money in excess of M0 translates into balance of payment deficits and gold outflows
• If money is in short supply (left of A = M0), balance of payments is in surplus and gold flows in
• Point A may correspond to a point with imbalances in current and capital account, e.g. a point where the current account deficit exactly matches the capital account surplus
• Thus, the gold standard results in a balance of payments equilibrium in the long-run, but not (necessarily) a current account or capital account equilibrium
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Monetary equilibrium under gold standard
• Financial markets support equilibrium: if money supply declines, interest rate increases, which attracts capital
• Over time, if a country is in short supply of gold money supply stringency creates increasing interest rates, growth slow-down, higher unemployment and a downward pressure on prices and wages
• All markets contribute to eliminate external imbalance, no need for government intervention (in theory)
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Rules of the game and problems
• Full gold convertibility at fixed price of all banknotes• Full backing. Central Bank holds same amount of gold as
notes issued• Complete freedom of trade and capital mobility
• Problems:• Sticky prices and wages (short-term disequilibria)• World money supply driven by discoveries and money
demand driven by economic growth go not hand in hand• Governments facing deficits tend to opt out of gold
standard
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Similarities to the EMU
• EURO replaces gold (no national money supply)• Hume’s mechanism works in Eurozone:
• Balance of payments surplus translates into EURO inflows• Balance of payments deficit translates into EURO outflows• Exchange rate cannot be used to equilibrate external
deficits• Adjustment has to work via prices and wages
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
The interwar period: the worst of all worlds
• Shipping gold became too dangerous and paper money starts circulating widely
• Yet the authorities attempt to carry on with the gold standard but:• No agreement on how to set exchange rates between
paper monies• An imbalanced starting point with war legacies
· High inflation· High public debts
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
The interwar period: three case studies
The British case: return to gold standard pre-war parity and refusal to devalue an overvalued currency relative to US breeds economic decline. Abolished unsustainable gold standard in 1931 and devalued currency by 30%. Cost: decade of miserable growth.
The French case: high debts hoping for German’s reparations, inflation soared after reparations failed. Return to gold standard and devaluation in 1928; undervaluation and beggar-your-neighbour policies protected economy first, but then others retaliate and the currency becomes overvalued, badly hit by Great Depression.
• The German case: hyperinflation, gold standard no option (reparations), devaluation and anti-inflation policy in 1924, turns into overvaluation in the early 1930s, and, finally, evading the choice of an appropriate exchange rate by resorting to ever-widening non-market controls under Nazi government.
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Lessons so far
We need a system, one way or another
• The gold standard – monetary unions – delivers automatic return to equilibrium, but at the cost of booms and recessions
• No agreement leads to exchange rate misalignments, competitive devaluations and trade wars
• Domestic misbehaviour undermine fixed exchange rates such as gold standard
• Exchange rate agreements require “rules of the game”, including a conductor, e.g. city of London before WW I
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
European post-war arrangements
An overriding desire for exchange rate stability• Initially provided by the Bretton Woods system• The US dollar as anchor and the IMF as conductor• Gold convertibility of US-$: 35 US-$ per ounce
• Once Bretton Woods collapsed, the Europeans were left on their own• The timid Snake arrangement• The European Monetary System• The European Monetary Union
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
European postwar arrangements (cont.)
The Bretton Wood collapse• Financing the Vietnam war by public debt which fueled
inflation and created large current account deficits • Diverging inflation rates and real appreciation pressures
of many currencies (e.g. DM)• Suspension of gold convertibility and realignment 1971
(devaluation of 10 %)• Collapse 1973
• The Snake arrangement• Agreeing on stabilizing intra-European bilateral parities• No enforcement mechanism: too fragile to survive• Diverging inflation rates across European countries
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
The EMS: Super Snake
Complements bilateral exchange rate commitments with a support mechanism
• Allows for prompt realignments to avoid misalignments• Emergence of the DM as the system’s anchor• But, still inflation divergence and misalignments kept
growing• 1992-93 speculative attacks alsmost destroyed EMS, IT and
UK left, realignments of IR, ESP, PT
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
From EMS to EMU (EURO)
EMS de facto doomed• Convergence to Bundesbank standards means that all other
countries lost monetary independence• Delors report prepared European Monetary and Financial
Union, plan for common currency• EMU plan adopted at Maastricht Summit 1989• 1999 exchange rates were irrevocably frozen, 2002 Euro
notes and coins were circulatred
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Lessons from history
Goldstandard
Inter-war
BrettonWoods
EMS EMU
Long-lasting misalignments must be avoided
Yes (auto-matic)
Yes Yes (not pos-sible)
Systems need to be built coherently
Yes Yes Yes Yes
Policy misbehaviour is ruled out
(largely) Yes
Systems must able to cope with shocks
Yes Yes
Conductor existing Yes Yes Yes Yes
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
The choice of an exchange rate regime
An question and the answer
• The question: what to do with the exchange rates: fixed or flexible?• Viewpoint of an individual country, in contrast to systems• Underlines the principles to evaluate the merits of a
monetary union
• The answer: there is no best arrangement• A matter of trade-offs
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Three basic principles
1 Long term: neutrality of money and PPP
2 Short term: non-neutrality of money, real and
monetary
matters interfere (cyclical fluctuations and shocks)
3 Interest parity condition
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
The long-term neutrality of money: theory
A
B
C
ADADlong-term AS short-term AS
output gap
Inflationrate
0
The AS-AD model output gap (Actual – Trend GDP)
AD: Why downward sloping?
Inflation erodes purchasing power of money and discourages consumption and investment
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
The long-term neutrality of money: theory
A
B
C
ADADlong-term AS short-term AS
output gap
Inflationrate
0
The AS-AD model output gap (Actual – Trend GDP)
AS: Why upward sloping?
Depression results in lower wages and lower prices of firm, while boom results in higher wage and price pressures
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
The long-term neutrality of money: theory
A
B
C
ADADlong-term AS short-term AS
output gap
Inflationrate
0
The AS-AD model output gap (Actual – Trend GDP)
Long-run:
If prices rise faster than wages, purchasing power declines, creates wage pressure, eventually we move back to long-run wage-price relation at C.
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Long term neutrality implication: PPP
• The real exchange rate• Defined as = EP/P*• E = nominal exchange rate; P = domestic price;
P* = foreign price• Purchasing Power Parity (PPP): E offsets changes in P/P*• So is constant
• Many caveats, though:• PPP seems to hold in the long run, but not in the
short and medium run
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Short term non-neutrality of money
• From AD-AS: the short-run AS schedule• So monetary policy matters in the short run• Channels of monetary policy
• The interest rate channel• The credit channel• The stock market channel• The exchange rate channel
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Monetary policy in the IS-LM model
A
CB
D
IS
IS‘
LM LM‘
Output-gap(Actual-Trend GDP)
foreignlevel
interest rate
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Monetary policy in the IS-LM model
A
CB
D
IS
IS‘
LM LM‘
Output-gap(Actual-Trend GDP)
Foreignlevel
interest rate
1. increase in money supply moves LM to LM‘,2. interst rates declines initially to B, 3. spending expands and economy moves to C4. capital flows out until interest rate is back to international level
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Monetary policy in the IS-LM model
A
CB
D
IS
IS‘
LM LM‘
Output-gap(Actual-Trend GDP)
Foreignlevel
interest rate
Flexible exchange rate:• currency depreciates• current account improves (IS shifts to IS‘)• output moves eventually to D
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Monetary policy in the IS-LM model
A
CB
D
IS
IS‘
LM LM‘
output-gap(Actual-Trend GDP)
Foreignlevel
interest rate
Fixed exchange rate:• Central Bank must intervene in exchange market• money supply shrinks until LM curve shifts back from LM‘ to LM and output to A
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Monetary policy in the IS-LM model
A
CB
D
IS
IS‘
LM LM‘
output-gap(Actual-Trend GDP)
Foreignlevel
interest rate
Thus, there is no room for monetary policy with a fixed exchange rate!
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Fiscal policy in the IS-LM model
A
B
C
IS
IS‘
LM LM‘
Output-gap(Actual-Trend GDP)
Foreignlevel
interest rate
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Fiscal policy in the IS-LM model
A
B
C
IS
IS‘
LM LM‘
Output-gap(Actual-Trend GDP)
Foreignlevel
1. Fiscal policy shifts IS curve to IS’.2. LM stays where it is.3. Output moves to B.4. The interest rate rises above foreign level.5. Capital flows in to restore interest parity
interest rate
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Fiscal policy in the IS-LM model
A
B
C
IS
IS‘
LM LM‘
Output-gap(Actual-Trend GDP)
Foreignlevel
Fixed exchange rate:• Central Bank intervenes to prevent currency appreciation• sells money such that increased money supply shifts LM to LM’• economy moves eventually to point C
interest rate
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Fiscal policy in the IS-LM model
A
B
C
IS
IS‘
LM LM‘
Output-gap(Actual-Trend GDP)
Foreignlevel
Flexible exchange rate:• Capital flows in and currency appreciates• Current account worsens• Demand declines• Eventually, IS’ shifts back to IS and the economy back to A
interest rate
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Fiscal policy in the IS-LM model
A
B
C
IS
IS‘
LM LM‘
Output-gap(Actual-Trend GDP)
Foreignlevel
Thus, fiscal policy does only work under fixed exchange rates in small open economies
interest rate
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Exchange rate regimes and policy effectiveness
Monetary policy
Fiscal policy
Fixed exchange rate
Ineffective Effective
Flexible exchange rate
Effective Ineffective
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
When does the regime matter?
• In the short run, changes in E are mirrored in changes in = EP/P*: P and P* are sticky
• In the long run, is independent of E: P adjusts• If P is fully flexible, the long run comes about
immediately and the nominal exchange rate does not affect the real economy
• Put differently, the choice of an exchange rate regime has mostly short run effects because prices and wages are sticky
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
What’s on the menu?
• Free floating (e.g. US, Eurozone)• Managed floating (e.g. Japan)• Target zones (e.g. ‘snake’)• Crawling pegs (e.g. Poland under transition)• Fixed and adjustable (e.g. Bretton Woods +-1%)• Currency boards (e.g. Estonia, Lithuania in 1990s)• Dollarization/Euroization• Monetary union
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
The choice of an exchange rate regime
• The monetary policy instrument• Can be useful to deal with cyclical disturbances• Can be misused (inflation)
• The fiscal policy instrument• Can also deal with cycles but is often politicized• Can be misused (public debts, political cycles)
• Exchange rate stability• Freely floating exchange rates move “too much” • Fixed exchange rates eventually become misaligned
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
The old debate: fixed vs. float
• The case for flexible rates• With sticky prices, need exchange rate flexibility to deal
with shocks• Remove the exchange rate from politicization• Monetary policy is too useful to be jettisoned
• The case for fixed rates• Flexible rates move too much (financial markets are often
hectic)• Exchange rate volatility: a source of uncertainty• A way of disciplining monetary policy• In presence of shocks, always possible to realign
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
The new debate: the two-corners solution
• Only pure floats or hard pegs are robust• Intermediate arrangements (soft pegs) invite government
manipulations, over or undervaluations and speculative attacks
• Pure floats remove the exchange rate from the policy domain
• Hard pegs are unassailable (well, until Argentina’s currency board collapsed…)
• In line with theory• Soft pegs are half-hearted monetary policy commitments,
so they ultimately fail
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
The two-corners solution and the real world
• Fear of floating• Many countries officially float but in fact
intervene quite a bit• Fear of fixing
• Many countries declare a peg but let the exchange rate move out of official bounds
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Fear of floating
80.00
90.00
100.00
110.00
120.00
130.00
140.00
1999M1 1999M7 2000M1 2000M7 2001M1 2001M7 2002M1 2002M7 2003M1 2003M7
Denmark (vis a vis €)Sweden (vis a vis €)Switzerland (vis a vis €)Korea (vis a vis $)
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
The two-corners solution and the real world
• Fear of floating is deeply ingrained in many
European countries
• Fear of fixing partly explains the disenchantment
with the EMS and some reluctance towards
monetary union
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration A Monetary History of Europe
Conclusions
• A menu hard to pick from: trade-offs are everywhere
• All of this takes the view from a single country• Systems involve many countries and rest on agreed
upon rules, including mutual support• Since the end of Bretton Woods, there is no world
monetary system• This leaves room for regional monetary systems.
Enters Europe’s experience
Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker
Theory and Politics of European Integration Optimal Currency Areas
Next lecture
• European Monetary Union (EMU)• European Growth and Stability Pact
• Reading:• Baldwin/Wyplosz (2009), Chs. 17-18