the international monetary system

Key issues Exchange rate regimes and their implications for the world economy  Possibilities of policy co-ordination  Policy co-ordination in Europe... Exchange rate regimesFree Gold

Chapter 34

The international monetary system

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

Key issues

 Exchange rate regimes and their

implications for the world economy

 Possibilities of policy co-ordination

 Policy co-ordination in Europe

Exchange rate regimes

Free

Gold standard

currency board Automatic

Adjustable peg Managed

float Some discretion

The gold standard

 Characteristics of the gold standard:

price of gold in terms of its domestic currency.

domestic currency into gold.

government's holding of gold.

 Adjustment to full employment is via

domestic wages and prices

– creating vulnerability to long and deep

recessions.

The adjustable peg and the dollar standard

 In an adjustable peg regime,

exchange rates are normally fixed,

but countries are occasionally

allowed to alter their exchange rate.

 Under the Bretton Woods system,

each country announced a par value for their currency in terms of US

dollars

– the dollar standard.

The dollar standard

 Faced with a balance of payments deficit under the dollar standard

 countries could try to avoid monetary

contraction by running down foreign

exchange reserves

 but devaluation could not be postponed

for ever, given finite reserves

 expansion of US money supply began to

spread inflation world-wide

Floating exchange rates

 Under pure/clean floating, forex markets

are in continuous equilibrium

 the exchange rate adjusts to maintain

competitiveness

 but in the short run, the level of floating

exchange rates is determined by

speculation

– given that capital flows respond to interest rate differentials.

Fixed versus floating exchange rates

– fixed rate system offers fundamental stability

– flexible rate system is potentially volatile

– but instability must be accommodated in other ways

under a fixed rate system

– fixed rate system imposes discipline and policy

harmonization.

International policy co-ordination

 Can a concerted attempt by a group of

countries to co-ordinate their policy bring benefits to the group?

 Externality argument:

can be avoided by agreement between

governments

 Reputation argument

governments to pre-commit to policies that

would otherwise not be credible

The European Monetary System

Community (including the UK) in 1979

 A system of monetary and exchange rate co-operation.

– which the UK did not join until 1990

– and it left again in 1992.

exchange rate volatility

– through co-ordination of monetary policy

– plus exchange rate controls

Chapter 35

European integration

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

Some key issues

 The European Single Market

– what difference did it make?

 Economic and Monetary Union (EMU)

– why did it happen?

– What difference will it make?

 Reform in Eastern Europe

– how are these countries faring in their transition from central planning to

market economies?

The Single Market

Single European Act

Objectives of the Single Market

 Abolition of remaining foreign exchange

controls on capital flows

 removal of non-tariff barriers within the EU

 elimination of bias in public sector

provisioning

 removal of frontier controls

 progress towards harmonization of tax

rates

Benefits of the Single Market

– removal of non-tariff barriers allows more exploitation of comparative advantage

Gains from the Single Market

0 5 10 15 20 25

Source: Allen, Gasiorek and Smith (1998)

From EMS to EMU

 A monetary union has

union

– an integrated financial market

– a single central bank setting the single interest rate for the union.

– to define ‘convergence’

with 11 member countries.

The Maastricht criteria

 Inflation rate

– no more than 1.5% above the average of the inflation

rate of the lowest 3 countries in the EMS

– no more than 2% above the average of the lowest 3 EMS countries

Sterling and Europe

0 10 20 30 40 50 60

% of UK trade

North Sea oil made the UK different

The UK is less integrated

with the rest of Europe

– but this is changing

The UK has a greater tradition of

macroeconomic sovereignty.

Black Wednesday and the ERM crisis

The UK’s business cycle was out

of phase with the rest of Europe.

The economics of EMU

 Optimal currency area

– a group of countries better off with a

common currency than keeping

separate national currencies

 3 key attributes (Mundell)

– countries that trade a lot with each

So is Europe an optimal currency area?

 Europe is ‘quite’ but not very closely integrated

 Some countries are more closely

integrated than others

 but the act of joining may itself feed the process of integration

A small Euroland member

faces a horizontal LM curve,

given that interest rates are

fixed by the ECB.

If the country is too small

to influence the ECB to alter

interest rates, either the

country must wait for wage &

prices to shift IS back via

improved competitiveness, Y1

IS1

Suppose an external shock

moves the IS curve to IS 1

or fiscal policy will be required to

enable more rapid adjustment.

Central and Eastern Europe

Eastern Europe:

some key issues

 On the eve of transition

– low per capita income

– high international debt

– crucial for prices to reflect true scarcity

– markets needed for products

– and physical capital/management skills

– firm and credible macro policy needed

– especially to avoid excessive inflation.

A progress report on the transition

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