Feb 17 2004

Lesson 4

By

John Kennes

International Monetary Economics

Feb 17 2004

Interesting Reads about IS-LM

1. What was lost with IS-LM (2003) working paper by Roger Backhouse and David Laidler. Highly critical.

2. Macroeconomics by Burda and Wyplosz (2001), chapter 10.

About money

1. Monetary Policy without Money: Hamlet without the Ghost (2003) working paper by David Laidler.

Some light reading

Feb 17 2004

EMS – Lecture 4. Chapter 12.

Optimum Currency Areas– Lecture 5. Chapter 13

EMU– Lecture 6. Chapter 14

Review– Lecture 7. Discussion of the project. Email any ideas in

advance.

Lectures on Monetary Systems

Feb 17 2004

What types of monetary systems are in the following regions?

EuropeAsiaNorth AmericaSouth America

Is European Monetary Integration exportable?

– Read: Barry Eichengreen (Dec 2002) Lessons of the Euro for the Rest of

theWorld http://emlab.berkely.edu/users/eichengr/policy

Monetary Systems around the world

Feb 17 2004

• The EMS was adopted in 1979 to preserve exchange rate stability within Europe.

• EU members were members of EMS, ERM (Exchange Rate Mechanism) initially optional

• ERM members were committed jointly to defend bilateral parity if necessary by unlimited interventions and loans. Realignments required consent of all members.

The European Monetary System

Feb 17 2004

1. ERM’s parity grid +/- 2.25%

2. Mutual SupportUnlimited committed. Consider DK and NL. Suppose krone weak.

The Dutch can produce its own currency in infinite amounts.

3. Joint Management of exchange rate realignmentsAll members of the ERM must agree. Avoid beggar thy neighbour

policies.

4. The ECUSymbolic creation of the European Currency Unit (ECU). Official

unit of account: basket of currencies, weighted by size of countries,

initially at parity with US dollar

4 main elements of the ERM

Feb 17 2004

The ECU: A basket of all EU currencies

Feb 17 2004

Phase 1: Inflation differed quite widely and realigments were

Frequent.

Phase 2: All countries decided to adopt Bundesbank’s low inflation

strategy, adopting the DM as an anchor and avoiding further

realignments.

Phase 3: 1992-93 crises -> wide margins, allowed ERM to survive

until launch of the euro.

Phases of the EMS

Feb 17 2004

1979-82: EMS-1 with narrow bands of fluctuations (+/- 2.25% and

symmetric.

1982-93: EMS-1 centered on the DM shunning realignments.

1993-99: EMS-1 with wide bands (+/- 15%)

1999- : EMS-2, asymmetric, on the way to the euro area

The four incarnations of the EMS

Feb 17 2004

The three phases of the EMS

Feb 17 2004

Improving on the snake to stabilize intra-European exchange ratesMutual supportRealignment unanimity rule

Respect the EU equalitarian approachNo centre currencyBilateral interventions by strong and weak currency central banks

No rule for the US dollar: Europe on its own

The EMS: Interpretation and Assessment

Feb 17 2004

The 1992 crisis provides an example of the impossible trinity.

• The liberalization of financial markets and the fixity of exchange rates was incompatible with divergent monetary policies, especially as Germany, the central country, was going through its unification shock.

The 1992 crisis and the impossible trinity

Feb 17 2004

The impossible trinity principle holds that the following cannot be

observed together

1. A fixed exchange rate2. Monetary policy independence3. Full capital mobility

Many of the ERM crises can be traced backed to failed attempts at

breaking this iron law.

The Impossible Trinity

Feb 17 2004

First a flexible arrangement:

• Different inflation rates: long run monetary policy independence (capital controls in devaluation prone countries)

• Frequent realignments

Evolution: From Symmetry to the DM Zone

Feb 17 2004

Evolution: From symmetry to the DM zone (inflation)

Feb 17 2004

But: realignments:

• Barely compensated accumulated inflation differences • Were easy to guess by markets• Put weak currency/high inflation countries on the spot

– Continuing current account deficits– Speculative attacks

• The symmetry was broken de facto• The Bundesbank became the example to follow

Evolution: From Symmetry to the DM Zone

Feb 17 2004

What did shadowing the Bundesbank require?

• Giving up much what was left of monetary independence.

• Aiming at a low German-style inflation rate• Avoiding realignments to gain credibility.

The DM Zone

Feb 17 2004

1. Bad design– Full capital mobility established in 1990 as part of the Single

Act: EMS in contradiction with impossible trinity unless all monetary independence relinquished.

2. Bad luck– German unification: a big shock that called for very tight

monetary policy– The Danish referendum on the Maastricht theory

3. A wave of speculative attacks in 1992-93– The Bundesbank sets limits to unlimited support

Why did the DM Zone breakdown?

Feb 17 2004

• The impossible trinity requires domestic monetary independence be abandoned if the exchange rate is rigidly fixed. Difficult when economic conditions differ (ex. Germany after reunification)

• If weaker currency countries impose restrictions on capital movements, speculative attacks were manageable. Once capital mobility … unlimted interventions are practically impossible.

• In particular, once an attack is started, defending parity implies offering the market one way bets. (i) Give up parity, speculators gain, (ii) hold parity, speculators do not lose.

• Monetary integration with separate currencies is risky.

What are the lessons?

Feb 17 2004

EMS-1 ceased to exist on 1 January 1999 with the launch of the euro.

EMS-2 was created to:• host currencies of existing EU members who

cannot/do not want to join euro area– Denmark and the UK have a derogation, but Denmark has

adopted the new ERM– Sweden has no derogation but has declined to adopt the new

ERM

• host currencies of new EU members before they are admitted into euro area– Potentially 10 new members.

EMS-2

Feb 17 2004

EMS-1 symmetric, no anchor currencyEMS-2 asymmetric, all parties defined by the euro

EMS-1 margin explicitly setEMS-2 normal (+/-2.25%) and standard (+/- 15%) bands

EMS-1 automatic unlimited interventionsEMS-2 ECB explicitly allowed to suspend intervention

How does the EMS-2 differ from the EMS-1?

Feb 17 2004

• In principle, ERM membership is compulsory for all new members

• They must stay at least two years in the ERM before joining the euro area.

• They must also eliminate capital controls• The impossible trinity says that they will have to give

up monetary policy• The risk of self-fulfilling crisis says that may not be

enough to avoid trouble.

Revival of the EMS?

Feb 17 2004

With the adoption of a singe currency, a new EMS was established.

How does EMS-2 differ from EMS-1?

• The euro is now the reference currency.• All EU members are required to take part in this new

exchange rate mechanism unless they have a derogation, which is the case of the UK, and, defacto, of Sweden.

• EMS-2 remains a prerequisite for joining the euro area. 10 new members of EU are to join the mechanism as of accession.

EMS-2