Feb 03 2004

Lesson 1

By

John Kennes

International Monetary Economics

Feb 03 2004

Professor: John KennesEmail: john.robert.kennes@econ.ku.dkOffice: Studiestræde 6 Telephone: 35 32 30 31Website: www.econ.ku.dk/kennes/

Office hours: by appointment (or just drop by)

Who is the professor?

Feb 03 2004

English

What is the teaching language?

Feb 03 2004

Final written exam

70%

Group projects

30%

How are grades determined?

Feb 03 2004

Baldwin, R and C. Wyplosz (2004) Economics of European Integration, McGraw-Hill

What is the textbook?

Feb 03 2004

Baldwin, R and C. Wyplosz (2004) Economics of European Integration, McGraw-Hill

Obstfeld, M. and K. Rogoff (1997) Foundations of International Macroeconomics, MIT press

What is the textbook?

Feb 03 2004

See the website and course outline for supplementary readings

What else do we have to read?

Feb 03 2004

Issues in monetary economics and the interaction of national economies through international financial markets. Topics such as balance of payments, foreign exchange markets, nominal and real exchange rate determination, and international parity conditions. Policy including exchange rate management, optimum currency areas, the history of international monetary system, adjustment mechanisms, and currency crises.

What is the course about?

Feb 03 2004

1. A monetary history of Europe2. The choice of exchange rate regime3. European Monetary System4. Optimum currency areas5. European Monetary Union6. Fiscal policy and the stability pack7. Financial markets and the Euro8. Economic integration and labor market

institutions

List of topics

Feb 03 2004

9. Cagan model of money and prices10. Money in the utility function11. Cash in advance12. Mundell-Flemming Dornbusch model13. Empirical evidence on sticky price models14. Models of credibility in monetary policy15. Search theoretic models of money

List of topics

Feb 03 2004

A reasonable question, however, ...

Why a microeconomist professor?

Feb 03 2004

My research looks at how decentralized agents choose pricing mechanisms: Auctions versus posted prices

Typical questions in International Monetary Economics consider optimal flexibility: flexible versus fixed exchange rates

An early macro model with auctions and posted prices is by Micheal Parkin

Parkin, M (1986) The Output-InflationTrade-off when Prices are Costly to Change, Journal of Political Economy

Why a microeconomist professor?

Feb 03 2004

Laidler, David (1999) The Exchange Rate Regime and Canada’s

Monetary Order, Bank of Canada working paper

Danmarks Nationalbank (2003) Monetary Policy in Denmark

(Pengepolitik i Danmark)

* Can be downloaded from the web

Read for next class*

Feb 03 2004

What type of monetary policy does Canada follow? What are the Bank of Canada’s objectives?What type of Monetary policy does David Laidler suggest

for Canada?Why?What type of monetary policy does Denmark follow? What are Danmarks Nationalbank’s objectives?Are these the same as the Bank of Canada?Why (not)?

What to think about?

Feb 03 2004

More questions on the website

www.econ.ku.dk/kennes

What to think about?

Feb 03 2004

Very helpful background reading is in chapter 1-3 of Baldwin and

Wyplosz

1. What has happened in Europe over the past 50 years? 2. Facts, Law, Institutions and the Budget3. Decision making

Chapter 1 is on the internet at the textbook website. (Read sample

chapter)

Where to start with the textbook?

Feb 03 2004

• Chapter 1 of Baldwin and Wyplosz illustrates 3 basic things

What has happened in Europe over the past 50 years?

Feb 03 2004

1. European integration has always been driven by political factors, ranging from a desire to prevent Franco-German war to a desire to share the fruit of integration with the newly democratic nations in Central and Eastern Europe.

– Yet while the goals were always political, the means were always economic

What has happened in Europe over the past 50 years?

Feb 03 2004

2. There have been basically three big increases in European economic integration.

– Formation of the customs union from 1958 to 1968 eliminated tariffs and quotas on intra-EU trade.

– The Single Market programme implemented between 1986 and 1992 (although elements are still being implemented today) eliminated many non-tariff barriers and liberalised capital flows within the EU.

– Finally, the European Economic and Monetary union melded together the currencies of most EU members.

What has happened in Europe over the past 50 years?

Feb 03 2004

3. Each of these steps towards deeper integration – but especially the customs unions and the Single market programme – engendered discriminatory effects that triggered reactions in the non-member nations.

– The discriminatory effects of EU integration has created a powerful gravitational force that has progressively drawn all but the most reluctant Europeans into the EU.

– If there is a lesson to draw from this for the future, it is that the 2004 enlargement is likely to greatly magnify the pro-EU membership forces in the nations further east and south.

What has happened in Europe over the past 50 years?

Feb 03 2004

• Chapter 2 of Baldwin and Wyplosz looks at four very different topics

Facts, Law, Institutions and the Budget

Feb 03 2004

• A dominant feature of the EU members is their diversity in size and income levels.

– In the EU15, there are only 5 large nations (40 million or more). The rest, with the exception of the Netherlands, are small or tiny, with national populations smaller than that of large cities like Paris or London.

– The 2004 enlargement will greatly increase this dispersion since out of the 10 newcomers, only Poland is large (almost 40 million citizens).

Facts

Feb 03 2004

– The economies of member states are also extremely disparate in size.

– Just 4 of the EU15 economies account for two-thirds of the EU15’s GDP, i.e. the economies of the other 11 members add up to only one-third of the EU15’s GDP.

– Again this dispersion will greatly widen with the 2004 enlargement. Taking all the 10 newcomers economies together will add only 5% to the EU15’s current GDP.

Facts

Feb 03 2004

• The EU is unique in that it has a supranational system of law. That is, on matters pertaining to the European Community, EU law and the EU Court take precedent over member states’ laws and Courts.

Law

Feb 03 2004

• While there are many EU institutions, only 5 really matter for most things. These are

– the European Council– the Council of Ministers– the Commission– the Parliament– the Court.

These 5 institutions work in concert to govern the EU and to pursue deeper and

wider European economic integration.

Institutions and legislative procedures

Feb 03 2004

• The EU budget is rather small, representing only 1% of the EU15’s GDP. It is spent mainly on

– the Common Agricultural Policy (half the budget), and on Cohesion,

– resources destined for poor regions in the EU (a third of the budget).

Budget

Feb 03 2004

• The budget is funded through four main mechanisms but in the final analysis, each EU member pays roughly 1% of its GDP. The distribution of net contributions (receipts minus contributions) by member state is quite unequal.

– In the EU15, the biggest net recipients are Luxembourg (the richest member) and the three poorest members (Greece, Portugal and Spain)

Budget: recipents

Feb 03 2004

Read chapter 3 of Baldwin and Wyplosz to refresh your thinking

about decision making in the Eurozone.

Decision making

Feb 03 2004

Policy making in various areas is categorised into

• areas where the EU has ‘exclusive competency’, i.e. where the decision is made only at the EU level,

• areas where competency is shared • areas where the EU has no competency, i.e. where

decisions are made only at the national or sub-national level

Decision making

Feb 03 2004

The allocation of policy areas to these three categories is determined

by the Treaties and decisions of the EU Court of Justice.

• To clarify the allocation, the EU operates on the principle of subsidiarity, which says that unless there is a good reason for allocating a task to the EU level, all tasks should be allocated to national or sub-national governments.

Decision making

Feb 03 2004

Four trade-offs:

• Diversity and information costs favour decentralised decision making.

• Scale economies favour centralisation. • Democracy-as-a-control-device favours

decentralisation.

• Jurisdictional competition favours decentralisation.

To centralize or maybe not to centralize?

Feb 03 2004

• Read chapter 10 of Baldwin and Wyplosz

• Also worth reading is Gros and Thygesen (1998)

A monetary history of Europe

Feb 03 2004

• Monetary union is the controversial end of a long process. History helps understand.

• Since paper money was invented, Europe’s monetary history has been agitated. Each bad episode carries important lessons.

• Before paper money, Europe was a de facto monetary union. Understand how it worked helps understand how the new union works.

Why study history?

Feb 03 2004

• Under metallic money (overlooking the difference between gold and silver) the whole world was really a monetary union

• Previous explicit unions only agreed on the metal content of coins to simplify everyday trading

Metallic Money

Feb 03 2004

• Bad money drives out good• If two monies circulate alongside each other (eg gold

and silver), and one of the currencies becomes overvalued, it is hoarded, and the other, depreciated currency is the only one that circulates.

• Gold discoveries in the 1850s

What is Gresham’s law?

Feb 03 2004

• The workings of the gold standard are described by David Hume’s price-specie mechanism

• Depends on (i) long-run neutrality of money and (ii) the effect of money on interest rates

• Money and the balance of payments are linked by trade flows

• Hume’s mechanism implies an automatic change in the money stock to achieve balance of payments equilibrium

• Figure 10.1

How did the Gold Standard work?

Feb 03 2004

• Money determines the price level in the long-run.• The price level affects the trade balance

– If domestic prices are relatively high (low), we have a deficit (surplus)

• Trade balance is achieved when the stock of money is M1

• Hume’s mechanism: Return to balance is automatic– If we start with deficit (point A, high money stock M ), money

flows out until we get back to balance

• Much the same story applies to the financial account– If the domestic interest rate is high (low), capital flows in (out)

and the return to balance is automatic

• The balance of payments adds the current and financial accounts

Hume’s price-specie mechanism

Feb 03 2004

• Full convertibility at fixed prices of banknotes issued by central banks– So paper money is merely a convenient surrogate to gold

• Full backing– Central bank holds at least as much gold as has been issued in

banknotes. In the presence of gold inflows the central bank prints money, with gold outflows it retires previously created money.

• Complete freedom in trade and capital movements– So as not to interfere with the two elements of the adjustment

mechanism

What factors give automaticity?

Feb 03 2004

• Euro replaces gold since national central banks are no longer allowed to issue national currencies and there is no exchange rate

• Within the Euro-zone, when one country runs a balance of payment surplus, it receives an inflow euros, and conversely in the case of a deficit

• The Hume mechanism is at work in Euroland– A deficit country can no longer use exchange rate to re-

establish competitiveness, and adjustments will have to work through prices and wages

– The rules of automaticity are part and parcel of Euro area membership

How is the Gold Standard related to the EMU?

Feb 03 2004

• Money starts circulating widely• Yet the authorities attempt to continue on with the

gold standard but– No agreement on how to set exchange rate between paper

currencies– An imbalanced starting point with war legacies

• High inflation• High public debts

The interwar period

Feb 03 2004

1. The British Case: A refusal to devalue an overvalued currency brings economic decline

2. The French Case: Devaluation, undervaluation and beggar-thy-neighbor policies, until others retaliate and currency becomes overvalued

3. The German Case: Hyperinflation, devaluation and finally, evading the choice of an appropriate exchange rate by resorting to ever widening non-market controls

The interwar period: Case studies

Feb 03 2004

1. We need a system, one way or another2. The gold standard – monetary unions – delivers

automatic return to equilibrium, but at the cost of booms and Recessions

3. No agreement leads to misalignments, competitive devaluations and trade wars

4. Agreements require “rules of the game”, including a conductor

Lessons so far

Feb 03 2004

An overriding desire for exchange rate stability

– Initially provided by the Bretton Woods system– The US dollar as anchor and the IMF as conductor

Once Bretton Woods collapsed, the Europeans were left on their own

– The timid Snake arrangement– The European Monetary System– The monetary union

Lessons so far