Lecture 9Lecture 9

International FinanceInternational Finance

ECON 243 – Summer I, 2005ECON 243 – Summer I, 2005

Prof. Steve CunninghamProf. Steve Cunningham

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Exchange Rate PolicyExchange Rate Policy

What exchange rate policy should a country What exchange rate policy should a country use? Is there a “best” exchange rate policy?use? Is there a “best” exchange rate policy? Clean FloatClean Float Fixed (never change)Fixed (never change) Dirty FloatDirty Float Adjustable PegAdjustable Peg

Each approach has its strengths and Each approach has its strengths and weaknesses.weaknesses.

Different countries might do well to choose Different countries might do well to choose different policies. There is no one right chose different policies. There is no one right chose that is correct for every country for all time.that is correct for every country for all time.

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Five Major Issues in ChoosingFive Major Issues in Choosing

1.1. The effects of macroeconomic The effects of macroeconomic shocks;shocks;

2.2. The effectiveness of government The effectiveness of government monetary and fiscal policies;monetary and fiscal policies;

3.3. Differences in macroeconomic goals, Differences in macroeconomic goals, priorities, and policies;priorities, and policies;

4.4. Controlling inflation;Controlling inflation;

5.5. The real effects of exchange rate The real effects of exchange rate variability.variability.

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ShocksShocks

Generally countries prefer exchange Generally countries prefer exchange rate policies that minimize shocks rate policies that minimize shocks because this results in a more stable because this results in a more stable economy. economy.

Types of shocks to consider:Types of shocks to consider: Internal ShocksInternal Shocks External ShocksExternal Shocks

The effects of shocks vary with The effects of shocks vary with exchange rate regime and with type of exchange rate regime and with type of shock.shock.

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Shocks (Overview)Shocks (Overview) Monetary and fiscal shocks operate like any Monetary and fiscal shocks operate like any

(deliberate) expansionary or contractionary (deliberate) expansionary or contractionary monetary or fiscal policy. monetary or fiscal policy. The analysis previously given applies.The analysis previously given applies.

An adverse international trade shock reduces An adverse international trade shock reduces both the current account and GDP, causing the both the current account and GDP, causing the country’s currency to depreciate.country’s currency to depreciate. The depreciation makes the country’s exports more The depreciation makes the country’s exports more

desirable, and exports improve, reversing the desirable, and exports improve, reversing the deterioration in the current account balance. GDP deterioration in the current account balance. GDP improves.improves.

The adjusting exchange rate always restores The adjusting exchange rate always restores external balance after a shock. It does not external balance after a shock. It does not always restore internal balance.always restore internal balance.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Internal ShocksInternal Shocks

Internal (domestic) shocks are generally Internal (domestic) shocks are generally less of a problem for a country under less of a problem for a country under fixed exchange rates.fixed exchange rates.

Monetary Shock:Monetary Shock: Domestic interest rate changes trigger capital Domestic interest rate changes trigger capital

flows and pressure on exchange rates.flows and pressure on exchange rates. Under a fixed rate, domestic monetary shocks Under a fixed rate, domestic monetary shocks

create a need for intervention which tends to create a need for intervention which tends to reverse and offset the shock.reverse and offset the shock.

Under a floating rate, the resulting change in Under a floating rate, the resulting change in the exchange rate magnifies the effect of the the exchange rate magnifies the effect of the shock.shock.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Internal Shocks (2)Internal Shocks (2)

Domestic Spending ShockDomestic Spending Shock This may be an unexpected change in C, I or G.This may be an unexpected change in C, I or G. Result depends upon how responsive international Result depends upon how responsive international

capital flows are to interest rate changes.capital flows are to interest rate changes. Under a fixed exchange rate, if capital Under a fixed exchange rate, if capital is not is not

responsiveresponsive, then it is less disruptive than under , then it is less disruptive than under floating rates.floating rates.

E.g., a decline in spending reduces imports, improving the E.g., a decline in spending reduces imports, improving the trade balance. The intervention required expands the trade balance. The intervention required expands the domestic money supply, lowering interest rates, and domestic money supply, lowering interest rates, and restoring aggregate demand.restoring aggregate demand.

Under a fixed exchange rate, if capital Under a fixed exchange rate, if capital is responsiveis responsive, , then domestic spending shocks are more disruptive then domestic spending shocks are more disruptive than under floating rates.than under floating rates.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Internal Shocks (3)Internal Shocks (3)

Domestic Spending Shock, Domestic Spending Shock, continuedcontinued Under floating rates, the changes in Under floating rates, the changes in

exchange rates tend to magnify exchange rates tend to magnify changes in domestic production and changes in domestic production and demand even more. demand even more.

The floating rate makes things worse.The floating rate makes things worse.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:External ShocksExternal Shocks

Foreign trade shocks are a major way in which Foreign trade shocks are a major way in which business cycles are transmitted from country to business cycles are transmitted from country to country. country.

Incomes fall in one country, resulting in declines Incomes fall in one country, resulting in declines in purchases of exports from another, which in purchases of exports from another, which reduces the incomes in the second country. reduces the incomes in the second country.

Consider a foreign trade shock:Consider a foreign trade shock: Example: demand for our exports fall.Example: demand for our exports fall. Under a float, the currency depreciates, making our Under a float, the currency depreciates, making our

exports cheaper in other countries.exports cheaper in other countries. Demand for exports rise.Demand for exports rise. Better under floating exchange rates.Better under floating exchange rates.

(Floating) Exchange rate changes insulate (Floating) Exchange rate changes insulate economies from foreign trade shocks.economies from foreign trade shocks.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:External Shocks (2)External Shocks (2)

International Capital ShocksInternational Capital Shocks Under a float, adverse effects of capital Under a float, adverse effects of capital

outflows result in exchange rate changes outflows result in exchange rate changes that cause offsetting improvements in that cause offsetting improvements in trade. trade.

Under a fixed exchange rate, the Under a fixed exchange rate, the intervention required tends to intervention required tends to exacerbate the negative effects of the exacerbate the negative effects of the int’l capital shock.int’l capital shock.

Floating rates are generally better.Floating rates are generally better.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Domestic Policy EffectivenessDomestic Policy Effectiveness

Fixed Exchange RatesFixed Exchange Rates:: Monetary policy is useless.Monetary policy is useless. Fiscal policy is made stronger.Fiscal policy is made stronger.

Floating Exchange RatesFloating Exchange Rates:: Monetary policy is reinforced by the exchange rate Monetary policy is reinforced by the exchange rate

change.change. The effectiveness of fiscal policy depends upon how The effectiveness of fiscal policy depends upon how

responsive capital is (capital mobility).responsive capital is (capital mobility). If capital is highly mobile, then fiscal policy is made If capital is highly mobile, then fiscal policy is made

stronger. If capital is not mobile, then fiscal policy is stronger. If capital is not mobile, then fiscal policy is made weaker.made weaker.

One thing is clearOne thing is clear: if a country wants to use : if a country wants to use monetary policy to conduct domestic policy, it monetary policy to conduct domestic policy, it will favor a floating exchange rate.will favor a floating exchange rate.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Goals, Priorities, and PoliciesGoals, Priorities, and Policies

Culture, history, exigencies, among Culture, history, exigencies, among other things, may result in countries other things, may result in countries having different goals and priorities. having different goals and priorities. These lead to different policies.These lead to different policies. Economic growthEconomic growth Low unemploymentLow unemployment Low inflationLow inflation External balanceExternal balance Income distribution equality or inequalityIncome distribution equality or inequality

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Goals, Priorities, and Policies (2)Goals, Priorities, and Policies (2)

To be successful, To be successful, fixed exchange ratesfixed exchange rates require require consistency or coordination in these areas.consistency or coordination in these areas. Multiple objectives within a country may require Multiple objectives within a country may require

conflicting policies, so priorities may be critically conflicting policies, so priorities may be critically important.important.

Independent monetary policies are not possible.Independent monetary policies are not possible. Tax, interest rate, or inflation rate differences will lead Tax, interest rate, or inflation rate differences will lead

to capital flows that will undermine the currency fix.to capital flows that will undermine the currency fix. Productivity and productivity growth differences affect Productivity and productivity growth differences affect

relative inflation rates.relative inflation rates. Recently the French complained that the British Recently the French complained that the British

should reduce the length of their workweek, and should reduce the length of their workweek, and Italy has complained that the level of the euro Italy has complained that the level of the euro has hurt them in international markets.has hurt them in international markets.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Goals, Priorities, and Policies (3)Goals, Priorities, and Policies (3)

Floating exchange rates are tolerant of Floating exchange rates are tolerant of diversity in countries’ goals, priorities, and diversity in countries’ goals, priorities, and policies.policies.

Changes in the exchange rates keep external Changes in the exchange rates keep external balance while internal changes occur. balance while internal changes occur.

The exchange rates insulate each country The exchange rates insulate each country from internal policies and shocks of other from internal policies and shocks of other countries. countries.

Int’l policy coordination is still possible, but Int’l policy coordination is still possible, but not necessary.not necessary.

This freedom only exists as long as the This freedom only exists as long as the countries involved do not care what countries involved do not care what exchange rate eventuates.exchange rate eventuates.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Goals, Priorities, and Policies (4)Goals, Priorities, and Policies (4)

For example, in the early 1980s, For example, in the early 1980s, unemployment rates were very high unemployment rates were very high in many European countries, but in many European countries, but they did not attempt expansionary they did not attempt expansionary policies because their currencies policies because their currencies were already weak against the dollar. were already weak against the dollar. They actually tightened monetary policy They actually tightened monetary policy

to raise their interest rates to prevent to raise their interest rates to prevent their currencies from weakening further.their currencies from weakening further.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:InflationInflation

An implication of PPP is that An implication of PPP is that relative stable relative stable prices is a requirement for a fixed exchange prices is a requirement for a fixed exchange rate.rate. The countries involved must have similar inflation The countries involved must have similar inflation

rates over the long run.rates over the long run. Thus, fixed exchange rates may create a Thus, fixed exchange rates may create a

necessary necessary price disciplineprice discipline on domestic policy on domestic policy to maintain low, stable inflation rates.to maintain low, stable inflation rates. Argentina’s inflation rate dropped from 3000% to Argentina’s inflation rate dropped from 3000% to

4% per year after they fixed their peso to the U.S. 4% per year after they fixed their peso to the U.S. dollar.dollar.

Inflationary expectations also lowered because of Inflationary expectations also lowered because of the credibility of the fixed-rate discipline.the credibility of the fixed-rate discipline.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Inflation (2)Inflation (2)

This This price disciplineprice discipline forces countries under fixed forces countries under fixed exchange rates to:exchange rates to: Keep their deficits small and similar,Keep their deficits small and similar, Keep their money supply growth rates low and steadyKeep their money supply growth rates low and steady This is the logic behind certain actions required of This is the logic behind certain actions required of

nations joining the European Union.nations joining the European Union. The result may be that a world under fixed The result may be that a world under fixed

exchange rates might enjoy lower global inflation exchange rates might enjoy lower global inflation rates.rates.

Under a fixed system with a “lead country”, like Under a fixed system with a “lead country”, like the U.S. under Bretton Woods, all countries will the U.S. under Bretton Woods, all countries will have to match the inflation rate of the lead have to match the inflation rate of the lead country.country.

When one country inflates, they all must inflate, When one country inflates, they all must inflate, which means that inflation can be “exported”.which means that inflation can be “exported”.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Inflation (3)Inflation (3)

No such pressures exist under floating No such pressures exist under floating exchange rates. Countries are free to exchange rates. Countries are free to conduct any domestic policies they wish.conduct any domestic policies they wish.

Budget deficits may be financed by money Budget deficits may be financed by money creation.creation.

This may lead to higher average global This may lead to higher average global inflation rates.inflation rates.

Average inflation rates were higher after Average inflation rates were higher after 1973 than before. 1973 than before.

The real keys to lower inflation rates are The real keys to lower inflation rates are policy discipline, resolve, and credibility of policy discipline, resolve, and credibility of the monetary authorities in each country.the monetary authorities in each country.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Exchange Rate VolatilityExchange Rate Volatility

Floating exchange rates Floating exchange rates dodo float! float! High variability of exchange rates can be High variability of exchange rates can be

a deterrent to trade and international a deterrent to trade and international investment because it raises exchange investment because it raises exchange rate risk, affecting total expected returns. rate risk, affecting total expected returns. (Exchange rate risk (Exchange rate risk isis exchange rate exchange rate variability.)variability.) Exchange rate variability has Exchange rate variability has real effectsreal effects..

Those who favor fixed exchange rates Those who favor fixed exchange rates claim that it reduces this variability, hence claim that it reduces this variability, hence improves int’l trade and investment.improves int’l trade and investment.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Exchange Rate Volatility (2)Exchange Rate Volatility (2)

Does exchange rate risk/variability Does exchange rate risk/variability actually reduce trade?actually reduce trade? Early studies typically found no effect Early studies typically found no effect

on the volume of international trade.on the volume of international trade. More recent studies found that More recent studies found that

exchange rate variability may affect exchange rate variability may affect trade volume, but the change is mostly trade volume, but the change is mostly negligible. negligible.

There is some concern that the There is some concern that the dramatic swings due to overshooting dramatic swings due to overshooting may lead to significant long-term may lead to significant long-term effects as capital formation is affected.effects as capital formation is affected.

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Choosing an Exchange Rate Regime:Choosing an Exchange Rate Regime:Exchange Rate Volatility (3)Exchange Rate Volatility (3)

Those who favor floating exchange rates argue that fixed Those who favor floating exchange rates argue that fixed exchange rates are just another form of exchange rates are just another form of price fixingprice fixing or or price controlsprice controls. The market is not being allowed to work.. The market is not being allowed to work.

As with all markets, equilibrium exchange rates are As with all markets, equilibrium exchange rates are prices that provide information (“send signals”) about prices that provide information (“send signals”) about the relative values of currencies. The question is whether the relative values of currencies. The question is whether or not the market might send or not the market might send “false signals”“false signals” for some for some reason.reason.

Price controls have been shown to be generally Price controls have been shown to be generally inefficient, while equilibrium rates are by definition inefficient, while equilibrium rates are by definition optimal optimal if they result from full information and full if they result from full information and full adjustmentadjustment..

Those who argue against floating exchange rates argue Those who argue against floating exchange rates argue that market exchange rates may be distorted by that market exchange rates may be distorted by speculation, speculative bandwagons and bubbles, speculation, speculative bandwagons and bubbles, informational problems, and adjustment problems.informational problems, and adjustment problems.

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Extreme Fixes: Extreme Fixes: Currency BoardsCurrency Boards

An “exchange rate only” monetary An “exchange rate only” monetary authority. authority. The board holds The board holds onlyonly foreign currency assets foreign currency assets

as official reserves.as official reserves. It issues domestic currency liabilities only in It issues domestic currency liabilities only in

exchange for foreign currency assets.exchange for foreign currency assets. It holds It holds nono domestic currency assets, so domestic currency assets, so

cannot sterilize actions.cannot sterilize actions. Because it focuses entirely on maintaining the Because it focuses entirely on maintaining the

fix, and not on domestic policy, and cannot fix, and not on domestic policy, and cannot sterilize, it has great sterilize, it has great credibilitycredibility in terms of its in terms of its commitment to the fixed exchange rate.commitment to the fixed exchange rate.

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Extreme Fixes: Extreme Fixes: Currency Boards (2)Currency Boards (2)

Hong Kong established a currency board in 1973. Hong Kong established a currency board in 1973. In the 1990s, Estonia, Lithuania, Bulgaria, and In the 1990s, Estonia, Lithuania, Bulgaria, and

Bosnia/Herzegovina established currency boards.Bosnia/Herzegovina established currency boards. Argentina set up a currency board in 1991, which Argentina set up a currency board in 1991, which

it abandoned in 2002.it abandoned in 2002. The creation of the board in 1991 was intended to The creation of the board in 1991 was intended to

increase the credibility of their anti-inflation stance.increase the credibility of their anti-inflation stance. Inflation fell dramatically, interest rates fell, and Inflation fell dramatically, interest rates fell, and

economic growth increased. Real growth was nearly 4% economic growth increased. Real growth was nearly 4% from 1992-1998.from 1992-1998.

But the fix made Argentina vulnerable to external But the fix made Argentina vulnerable to external shocks. Following the Mexico peso crisis hit in 1995, int’l shocks. Following the Mexico peso crisis hit in 1995, int’l investors started pulling out of Argentina. Defending its investors started pulling out of Argentina. Defending its fix, Its money supply shrank and interest rates rose. This fix, Its money supply shrank and interest rates rose. This ultimately threw the country into recession in 1998.ultimately threw the country into recession in 1998.

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Extreme Fixes: Extreme Fixes: Currency Boards (3)Currency Boards (3)

The Argentine government ultimately had The Argentine government ultimately had to allow the exchange rate to float.to allow the exchange rate to float. The currency board does not force a country to The currency board does not force a country to

follow sensible fiscal and regulatory policies.follow sensible fiscal and regulatory policies. The fixed exchange rate leaves the country The fixed exchange rate leaves the country

more exposed to adverse foreign shocks.more exposed to adverse foreign shocks. It is difficult to find a “graceful” It is difficult to find a “graceful” exit strategyexit strategy

that allows the country to abandon the fix and that allows the country to abandon the fix and allow rates to float.allow rates to float.

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Extreme Fixes: Extreme Fixes: DollarizationDollarization

An extreme form of a fixed exchange An extreme form of a fixed exchange rate is for a country to abolish its own rate is for a country to abolish its own currency and use the currency of some currency and use the currency of some other country.other country.

Because the “other currency” is often Because the “other currency” is often the U.S. dollar, this is called the U.S. dollar, this is called dollarizationdollarization..

The government can still The government can still “de-“de-dollarize”dollarize” and reintroduce local and reintroduce local currency.currency.

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Extreme Fixes: Extreme Fixes: Dollarization (2)Dollarization (2)

In 1999, the president of Argentina In 1999, the president of Argentina talked about adopting the dollar, but did talked about adopting the dollar, but did not follow through.not follow through.

In 2000, Ecuador dollarized.In 2000, Ecuador dollarized. In 2001 El Salvador dollarized.In 2001 El Salvador dollarized. Dollarization makes it much harder for a Dollarization makes it much harder for a

country to retake control of its currency country to retake control of its currency and devalue, so adds to its credibility. and devalue, so adds to its credibility.

It removes exchange rate risk, especially It removes exchange rate risk, especially in terms of trade with the U.S.in terms of trade with the U.S.

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Extreme Fixes: Extreme Fixes: Dollarization (3)Dollarization (3)

What is the cost of dollarization?What is the cost of dollarization? The country gives up control over all The country gives up control over all

monetary policy, leaving it in the hands monetary policy, leaving it in the hands of the U.S. Federal Reserve.of the U.S. Federal Reserve.

It sells its U.S. bonds to buy the dollars, It sells its U.S. bonds to buy the dollars, which means that it no longer collects which means that it no longer collects bond interest. This can be a large income bond interest. This can be a large income for some countries. (It loses for some countries. (It loses seigniorageseigniorage.).)

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Precursors to the EUPrecursors to the EU

• Benelux (1944): Belgium, Netherlands, and Luxembourg established a customs union.

• May, 1952: the six-nation European Coal and Steel Community (ECSC) was created. (The Benelux nations with Germany, France, and Italy.)

• March 1957: The Treaty of Rome established the European Economic Community (EEC) and the European Atomic Energy Commission (Euratom).

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Objectives of the EECObjectives of the EEC

To gradually phase out all tariffs To gradually phase out all tariffs among the member nations.among the member nations.

Replace the old tariff system with a Replace the old tariff system with a single external tariff system.single external tariff system.

Create a system that allowed for the Create a system that allowed for the free movement of goods, labor, and free movement of goods, labor, and capital among the six. capital among the six.

Charles de Gaulle (France) pushed for Charles de Gaulle (France) pushed for agricultural integration to parallel the agricultural integration to parallel the industrial integration.industrial integration.

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More HistoryMore History In 1958, Britain called for the EEC to be expanded In 1958, Britain called for the EEC to be expanded

into an Atlantic free-trade zone.into an Atlantic free-trade zone. France vetoed the proposal.France vetoed the proposal. Rejected, in 1959 Britain, Portugal, Switzerland, Rejected, in 1959 Britain, Portugal, Switzerland,

Austria, Sweden, Norway, and Finland formed the Austria, Sweden, Norway, and Finland formed the European Free Trade Association (EFTA).European Free Trade Association (EFTA).

In 1961, Britain again asked for EEC membership, In 1961, Britain again asked for EEC membership, but de Gaulle of France again vetoed the admission.but de Gaulle of France again vetoed the admission.

In 1962, a Dutch proposal (the “Mansholt”) was In 1962, a Dutch proposal (the “Mansholt”) was accepted, leading to a common agricultural policy accepted, leading to a common agricultural policy among the EEC nations.among the EEC nations.

1965—the “Second Treaty of Rome”.1965—the “Second Treaty of Rome”.

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Second Treaty of RomeSecond Treaty of Rome This, the second Brussels Treaty, created the This, the second Brussels Treaty, created the

European Community (EC).European Community (EC). The ECSC, the EEC, and Euratom were all merged The ECSC, the EEC, and Euratom were all merged

together.together. A four-part governing body, consisting of a A four-part governing body, consisting of a

Commission, Council, Parliament, and Court.Commission, Council, Parliament, and Court. In 1967, Britain was AGAIN rejected for member In 1967, Britain was AGAIN rejected for member

by a French veto.by a French veto. 1973—Britain, Denmark, and Ireland were 1973—Britain, Denmark, and Ireland were

admitted to the EC. admitted to the EC. In 1981, Greece was admitted.In 1981, Greece was admitted. In 1986, Spain and Portugal were admitted.In 1986, Spain and Portugal were admitted.

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Treaty of MaastrichtTreaty of Maastricht In December 1991, the Treaty of In December 1991, the Treaty of

Maastricht was approved by the EC.Maastricht was approved by the EC. This Treaty had three “pillars”:This Treaty had three “pillars”:

Monetary UnionMonetary Union Common Foreign and Security PoliciesCommon Foreign and Security Policies Cooperation in Justice and Home Affairs.Cooperation in Justice and Home Affairs.

Believing that a single market requires Believing that a single market requires a single currency, the Maastricht a single currency, the Maastricht Treaty called for the creation of the Treaty called for the creation of the European Monetary Union (EMU) in European Monetary Union (EMU) in three stages.three stages.

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European Monetary Union European Monetary Union (EMU)(EMU)

Stage 1 (1991). Convergence in 5 ways:Stage 1 (1991). Convergence in 5 ways: Inflation ratesInflation rates Interest ratesInterest rates Currency exchangeCurrency exchange Rate stabilityRate stability Debt-to-GDP ratio of less than 60%Debt-to-GDP ratio of less than 60%

Stage 2 (1994). Creation of a European Stage 2 (1994). Creation of a European Central Bank (ECB).Central Bank (ECB).

Stage 3 (1997).The ECB would be Stage 3 (1997).The ECB would be responsible for monetary policy and the responsible for monetary policy and the euro would circulate as bank money.euro would circulate as bank money.

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Convergence CriteriaConvergence Criteria Each country’s inflation rate must be no higher Each country’s inflation rate must be no higher

than 1.5 percentage points above the average of than 1.5 percentage points above the average of the inflation rates of the three countries with the the inflation rates of the three countries with the lowest rates.lowest rates.

Each country’s exchange rates must be maintained Each country’s exchange rates must be maintained within the prescribed trading band with no within the prescribed trading band with no realignments during the preceding two years.realignments during the preceding two years.

Each country’s long-term interest rates (gov’t Each country’s long-term interest rates (gov’t bonds) must be no higher than 2 percentage points bonds) must be no higher than 2 percentage points above the average of the three lowest.above the average of the three lowest.

Each country’s budget deficit must be no more than Each country’s budget deficit must be no more than 3% of its GDP, and its gross gov’t debt no larger 3% of its GDP, and its gross gov’t debt no larger than 60% of its GDP.than 60% of its GDP.

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European Monetary UnionEuropean Monetary Union Exchange Rate Mechanism (ERM)Exchange Rate Mechanism (ERM) established to established to

create a monetary union and eventually a single create a monetary union and eventually a single currency—currency—the eurothe euro.. In a In a monetary unionmonetary union, exchange rates are permanently , exchange rates are permanently

fixed, with a single monetary authority (central bank) fixed, with a single monetary authority (central bank) conducting monetary policy for the entire union.conducting monetary policy for the entire union.

The ERM was an adjustable-peg system, used as The ERM was an adjustable-peg system, used as the entering nations brought their monetary and the entering nations brought their monetary and fiscal policies into line with one another.fiscal policies into line with one another.

Eleven EU countries joined in 1999 with one Eleven EU countries joined in 1999 with one more joining in 2001.more joining in 2001.

With its low inflation rates, economic size and With its low inflation rates, economic size and prestige of its central bank, Germany was prestige of its central bank, Germany was generally regarded as the generally regarded as the lead countrylead country..

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European Monetary UnionEuropean Monetary Union

In May 1998, there was a summit of In May 1998, there was a summit of EU leaders to decide which countries EU leaders to decide which countries met the five criteria.met the five criteria.

They decided that 11 countries had They decided that 11 countries had met the criteria and could be met the criteria and could be admitted to the monetary union. admitted to the monetary union. (Other countries could join later (Other countries could join later when they met the criteria.)when they met the criteria.)

Britain, Denmark, and Sweden Britain, Denmark, and Sweden qualified but chose not to join.qualified but chose not to join.

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European Central Bank (ECB)European Central Bank (ECB) Center of the European System of Central Banks.Center of the European System of Central Banks. On January 1, 1999, the ECB assumed On January 1, 1999, the ECB assumed

responsibility for the union-wide monetary policy.responsibility for the union-wide monetary policy. Each country gives up (independent) monetary Each country gives up (independent) monetary

policy, and, because of potential effects on policy, and, because of potential effects on deficits, has limited access to fiscal policy. deficits, has limited access to fiscal policy. Can these countries function solely on limited fiscal Can these countries function solely on limited fiscal

policy?policy? The anticipated gains are the elimination of all The anticipated gains are the elimination of all

exchange rate concerns within the union, exchange rate concerns within the union, eliminating all foreign exchange transactions eliminating all foreign exchange transactions costs. costs.

It was a centerpiece toward larger-scale It was a centerpiece toward larger-scale economic integration.economic integration.

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Floating the EuroFloating the Euro

On January 1, 1999, the European On January 1, 1999, the European Monetary Union (EMU) was inaugurated, Monetary Union (EMU) was inaugurated, leading to the introduction of a new leading to the introduction of a new currency, called the currency, called the euroeuro. .

On January 1, 2002, euro currency began On January 1, 2002, euro currency began to circulate in Europe.to circulate in Europe.

On February 28, 2003, all other currencies On February 28, 2003, all other currencies were withdrawn from circulation.were withdrawn from circulation.

By July 2002, the euro was trading evenly By July 2002, the euro was trading evenly with the U.S. dollar.with the U.S. dollar.

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European UnionEuropean Union

Under a single currency, with a Under a single currency, with a common commercial code, labor laws, common commercial code, labor laws, etc., product and labor mobility should etc., product and labor mobility should be extremely high and costless. be extremely high and costless.

This allows Europe to operate This allows Europe to operate economicallyeconomically like one very large like one very large nation.nation.

A European Constitution?A European Constitution? Recent problems.Recent problems.