Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 6 A Monetary...

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



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



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



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.



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



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



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



Neutrality of money and current account equilibrium

gold money

price level

P1

M1 M0

A

current account deficit

current account surplus



Neutrality of money and current account equilbrium

gold money

price level

P1

M1 M0

A



Money determines the price level (in the long run)




gold money

price level

P*

M1 M0

A



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




gold money

price level

P1

M1 M0

A



Trade balance is achieved when the stock of money is M1, and, hence, domestic prices equal P*.



Balance of payment equilibrium

gold money0

M0

AC B‘ B

outflow of moneyinflow of money

BoP



Balance of payment equilbrium

gold money0

M0

A

C

B‘ B


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



Balance of payment equilbrium

gold money0

M0

AC

B‘

B


• 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



Financial account equilibrium

gold money

interest rate

i*

M2M0

A

financial account surplusfinancial account deficit




gold money

interest rate

i*

M2M0

A


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




gold money

interest rate

i*

M2M0

A


Thus, if i > i*, capital account is in surplus, and if i < i* it turns into a deficit• Equilibrium is achieved if i = i*




gold money

interest rate

i*

M2M0

A


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



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



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)



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



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



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



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.



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



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



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



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



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



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



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



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



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




A

B

C


output gap

Inflationrate

0


AS: Why upward sloping?

Depression results in lower wages and lower prices of firm, while boom results in higher wage and price pressures




A

B

C


output gap

Inflationrate

0


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.



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



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



Monetary policy in the IS-LM model

A

CB

D

IS

IS‘

LM LM‘

Output-gap(Actual-Trend GDP)

foreignlevel

interest rate




A

CB

D

IS

IS‘

LM LM‘


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




A

CB

D

IS

IS‘

LM LM‘


Foreignlevel

interest rate

Flexible exchange rate:• currency depreciates• current account improves (IS shifts to IS‘)• output moves eventually to D




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




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!



Fiscal policy in the IS-LM model

A

B

C

IS

IS‘

LM LM‘


Foreignlevel

interest rate




A

B

C

IS

IS‘

LM LM‘


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




A

B

C

IS

IS‘

LM LM‘


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




A

B

C

IS

IS‘

LM LM‘


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




A

B

C

IS

IS‘

LM LM‘


Foreignlevel

Thus, fiscal policy does only work under fixed exchange rates in small open economies

interest rate



Exchange rate regimes and policy effectiveness

Monetary policy

Fiscal policy

Fixed exchange rate

Ineffective Effective

Flexible exchange rate

Effective Ineffective



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



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



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



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



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



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



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 $)



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



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


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

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